Zero Rates Environment
Investing in a zero rates environment is particularly problematic for the traditional 60-40 retirement portfolio of stocks and bonds.
If fact, investing in a zero rates environment has meant that the traditional retirement portfolio of stocks and bonds is down by 20% for the fourth time since WWII.
The 60% stocks and 40% bonds portfolio lost value during the energy crisis recession of the 70s in 1974 and in September 2002. The financial crisis of 2008 and the Great Recession that ensued also led to negative returns the traditional 60-40 portfolios in 2009, according to Michael Batnick of Ritholtz Wealth Management.
What is the big issue of investing in a zero rates environment today, 2020?
It is the depressed level of income and spending, reflected in the current US level of the unemployment rate of around 10%, which has become a major theme of investing in a zero rates environment.
Moreover, the longer this post-pandemic economy remains in a quagmire of depressed income and spending the more vulnerable the most indebted companies will be in this set of circumstances.
So the governments through fiscal spending and central banks by the creation of currency to purchase assets are attempting to make up for this loss of income, consumption, and investing.
The ballooning public deficit and the Fed’s emergency monetary easing policy have laid the foundations for investing in a zero rate environment
The takeaway of this piece is that investing in a zero rates environment has implications for investors; that being that the traditional 60% stocks and 40% bonds portfolio will under-perform.
“We have just had a fourth fiscal program. Imagine having to do that in eight quarters in a row to make up for the low level of income and spending in the economy,” said Bob Prince from Bridgewater Associates.
“Imagine the potential on the dollar on inflation and the effects on other assets” said Bob Prince.
That is a thought worth pondering over bearing in mind this combination of economic malaise, due to depressed income and consumption combined with central bank liquidity expansion.
Investing in a zero rates environment has implications for bonds and the traditional 60/40 portfolios
“From the bond perspective you have zero returns and you have an asymmetric return because you have no limit to how much the bond yields can go up. So, you could make 5-6% over the next 5 years or so, but you could lose 20-30% if you have some type of normalization of real yields and rising inflation,” said Bob Prince. “So, you have that asymmetry in the bond market and you are not getting paid any returns” he added.
Investing in a zero rates environment could also lead to unstable support levels for stocks
“You have taken away the floor an equity decline and an economic decline, earnings are falling but if bond yields are falling it lowers the discount rates and supports prices. If you can’t lower the discount rate on those earnings the downside is bigger. “If you can’t cut interest rates, then you can’t put a floor under the economy, except through monetization and fiscal policy which threatens the currency” said Bob Prince
Indeed, the central banks have proven, to date, that they will keep creating currencies to prevent an implosion.
So QE infinity which I said on April 8, 2019 “could now be a reality” has indeed played out, particularly in the post-pandemic economy.
Moreover, I said that this would debase the US dollar and that smart money capital flow would go into precious metals and even cryptocurrencies as a countermeasure for wealth protection.
Back in January 2019, “I wrote a nasty downturn in the economic cycle could expose the Emperor with no clothes, Fed impotence could trigger a run on the dollar and dollar leveraged assets. The ultimate haven asset, gold could take a moon shot”.
That has played out, gold is up over 34% year to date, silver over 60% over the same period, and the USD has had its worse month in July in a decade
So is the crisis hedge, in other words, assets that are inversely correlated to the US dollar and risk assets, the next play to investing in a zero rates environment?
Bob Prince from Bridgewater Associates sees it as more of a reflation than a crisis hedge, reflation goes to the point that foreign investors are willing to hold dollar-denominated bonds. “Reflationary periods are so damaging to the economy that the government the central bank will do everything in their power to devalue the currency and print money. Gold is a counter currency the value” he said.
“Typically, a store of wealth is a wealth preservation strategy, but in the current world because of the excess liquidity store of wealth is where liquidity capital flow” said Bob Prince.
As we said, “capital flows are the holy grail of forecasting future asset prices”.
Does investing in zero rates environment, with the 10-year treasury yields below 1% mean betting against the US dollar?
“I think we are in long term transition away from the dollar as a reserve currency it won’t happen overnight” said Bob Prince Bridgewater Associates. Moreover, the weaponization of the dollar could accelerate that trend, provided that there are other viable alternatives to the US dollar.
Nevertheless, Bob Prince thinks that massive fiscal and monetary expansion is bullish for US assets in the short term. But from a longer perspective, he is worried about currency debasement.
What are the potential snakes and ladders of investing in zero rates environment?
“Massive creation of liquidity will drive down the risk premiums of assets that can serve as a store hold of wealth, the economic destruction caused by the low level of income and spending will drive up the risk premiums. That will ultimately destroy the balance sheets of companies that don’t get that liquidity. So, there will be a differentiation between those companies, countries that get the liquidity that drive down risk premiums” he said.