The ‘lower for longer’ interest rate environment we currently find ourselves in has some profound implications for investors taking a long-term outlook.
This is because the return generated by cash is also a component of the returns generated by other asset classes. Therefore, for asset allocators, the effective reduction in cash returns means that purchasing real assets, such as property, now appears to be a better value decision. And while nominal assets, such as bonds, are still relatively expensive they too have become cheaper than they were.
Calculating the value of long-term asset returns allows investors to make a comparison with today’s price. After all, “price is what you pay, value is what you get” or so said the Sage of Omaha.
While the approach to do this will vary slightly across the industry, broadly speaking long-term asset returns are calculated by taking the nominal government bond yield, built from nominal cash returns plus a government bond risk premium, to which risk premia for risky assets are added.
For example, the expected UK equities long-term return is currently around 5.6 per cent but buying today would potentially give a 7 per cent return. We can therefore conclude that UK equities are getting cheaper when volatility is factored in.
Events in the macroeconomic environment will of course have an impact on these calculations. Recently there has been a fundamental shift in the longer-term equilibrium level of real cash rates as a result of changes to global spot and forward rates, as well as commentary issued by central banks, particularly in UK and US. We read about this almost daily as ‘lower for longer’ headlines fill our newspapers.
Both the real cash rates and inflation rates for Europe have also reduced, reflecting structural differences in Europe that result in lower real cash rates and structurally lower inflation rates in the medium and longer-term.
While market expectations for a rate hike in the UK have been pushed back from the first quarter of 2015 to the second half of the year, it now looks likely that the US Federal Reserve will be the first of the major advanced economy central banks to hike rates, probably around mid-2015.
By comparison, the Bank of Japan and the ECB are undertaking further monetary easing measures.
Interest rates in the US and UK may rise sooner than expected though currently disinflationary pressures exist, largely stemming from lower commodity prices. Likewise interest rates could rise if central bankers decide that there is less economic slack than they had originally anticipated. This has the potential to result in market volatility as investors react to the short-term noise.
However, in the medium-term the market expects interest rates to “normalise”, but central bankers continue to stress that these are likely to be lower than historical norms.
This is visible in the UK with interest rates expectations moving sharply downwards. At the start of this year the market expected interest rates to stabilise at 4 per cent by 2019/2020 but that expectation has since fallen to 2.5 per cent.
