MYSay: Seeking returns in a low-interest-rate environment

This article first appeared in Forum, The Edge Malaysia Weekly, on December 21, 2020 - December 27, 2020.
Fed chairman Jerome Powell signalled that the US central bank will tolerate inflation for  a longer period of time, one of the traditional triggers for rate increases. (Photo by Reuters)

Fed chairman Jerome Powell signalled that the US central bank will tolerate inflation for a longer period of time, one of the traditional triggers for rate increases. (Photo by Reuters)

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Interest rates have reached their lowest levels in five years. For example, the US Federal Reserve (Fed), responding to what is likely to be the deepest economic downturn since the Great Depression, first dialled back its benchmark rates to the 0% to 0.25% range in March, down from the 1.50% to 1.75% at the start of the year. The move was one of many aggressive fiscal and monetary measures designed to inject the lifeblood of liquidity to help nurse the US economy back to recovery.

So far, the road to recovery has been mixed due to the unpredictable and disruptive impact of the coronavirus worldwide, and the intermittent outbursts in US-China tensions.

And it seems that no one is expecting an increase in interest rates soon, especially after Fed chairman Jerome Powell signalled that the US central bank will tolerate inflation for a longer period of time, one of the traditional triggers for rate increases. If history is any guide, in the aftermath of the financial crisis of 2008, the Fed cut interest rates to zero too and kept them there for seven years.

What low interest rates mean

When interest rates are low, borrowers have the upper hand. Whether they are individuals or corporations, they pay less on what they owe. That said, prospective borrowers looking to take advantage of lower rates by applying for new loans may have to contend with credit tightening, as financial institutions adopt a more cautious stance in response to the uncertain economic outlook.

Savers, by comparison, are in a quandary, as low rates translate into lower interest earnings and may even result in their savings shrinking in the face of inflation. To make up for the shortfall, they either have to be more frugal in their spending habits or look for accounts that offer better rates, even if only marginally.

For investors, the story is more nuanced.

Near-zero interest rates tend to boost the market’s valuation of stocks for two reasons. Companies that are creditworthy can borrow cheaply. Central banks hope this will help spur investments and generate growth, which is their motivation for reducing interest rates.

The interest rate is also the rate at which the future earnings of a company are discounted when calculating its present-day value. That is the second reason stock prices rise when rates are lowered — future earnings, discounted at a lower rate, experience a boost in value in current dollar terms.

Meanwhile, returns on fixed-income instruments such as from bond yields will suffer due to low interest rates. The risk on fixed-income investment also rises, as the ultra-low yield does not provide sufficient buffer against future rate increases or inflation.

In such a low-rate environment, investors may have to be more proactive in adjusting their portfolio mix so it has a higher stock-to-bond ratio.

Staying invested in uncertain and volatile times

Just how large a shift in allocation is appropriate will depend on multiple factors, not least of which is the investor’s time horizon. Investors who are close to retirement would be holding a portfolio that is mainly made up of short-duration bonds ayway — no matter what the level of interest rates is. In such cases, the room for manoeuvre is rather limited.

Individual investors with longer time horizons, and who can hence accept more volatility, should consider holding a higher proportion of equities that will benefit from the upside to stock prices.

Beyond bonds and stocks, there is another investment option — gold, which is accessible to large and small investors alike.

Gold tends to perform well in a low-interest-rate environment, when the opportunity cost of holding it is low. Moreover, compared with getting negative yield on some European and Japanese government bonds, not actually losing money when one holds gold becomes an attractive proposition.

Gold is often seen as a hedge against inflation, which some investors are worried about given the massive government liquidity injection that is happening globally. These factors explain why the precious metal has been on a tear, up by more than 20% since the start of the year.

The path between inaction and overzealousness

Working out the best strategy in a low-interest-rate period is a complex task, as markets do not follow straight-line trajectories. They can be unpredictable, and at times experience bouts of high volatility, as attested to by the double-digit swings in the share prices of Apple and Tesla in recent weeks. We would therefore advise investors against trying to time the market.

Besides recommending the usual geographical and sectoral diversification, advisers may suggest new areas of investments, such as funds or companies that display positive environmental, social and governance attributes, as an attractive alternative.

If one does not have easy access to professional advisers, robo-advisory can be a good option for automatic asset reallocation that is adjusted based on risk profiles and market conditions.

Whatever the future may hold, a prudent stance amid the current uncertainty requires investors to be disciplined, to stay invested and to practice diversification by spreading one’s portfolio over a wider range of investments.

Inaction in the face of low interest rates implies accepting next to zero returns, while overzealous yield and return chasing brings its own set of dangers, including exposing oneself to unintended, higher risks.

Dharmo Soejanto is head of investment partnerships and solutions at UOB Asset Management

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