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A low-growth, low-interest rate environment is firmly established globally, and a combination of external forces look set to inhibit any improvement for years to come. This makes investors’ hunt for income more complicated than ever.
Global growth is low and any improvement this year will be precarious; growth is set to slow further in the next few years.
Deflationary forces that emerged during the financial crisis evidently remain at work, and inflation expectations remain doggedly low.
Central banks are having to revise their strategy: it is no longer the time to raise interest rates.
Rates are set to remain lower for longer, with demographic and economic factors – including an ageing population and reduced productivity – adding to downward pressure on rates
Investors are seeing a new paradigm of persistently low interest rates, and will have to adapt to this environment in which interest rates are set to remain low for a long time. Rarely in recent times have short-term interest rates in developed countries been so firmly grounded, paving the way for even lower rates along the whole of the curve, over a longer period than had been expected just a few months ago.
The reasons for this are first of all cyclical. Central banks, which were continuing or just starting to normalise their monetary policy, were caught off guard by the slowdown in world growth.
According to the latest International Monetary Fund (IMF) forecasts released at the start of April, 70% of the global economy is likely to slow in 2019. World growth will probably reach 3.5% this year and 3.6% in 2020, compared with 3.8% in 2018. This slowdown will be even more pronounced in developed countries, where growth looks set to drop from 2.3% in 2018 to 2% in 2019 and 1.7% in 2020.
The US will probably lose momentum with growth of 2.3% this year and 1.9% in 2020, following the gradual withdrawal of fiscal stimulus. The adjustment is even more drastic in the euro zone with a forecast of 1.3% for 2019, against 1.6% previously.
Much of the blame for the euro zone slowing lies with Germany, where growth has slowed sharply and is unlikely to exceed 0.8% in 2019 due to slower external demand and difficulties facing the automobile industry. Italy also represents a drag on growth, where a rate of 0.1% is predicted. While China is slowing too, its growth rate significantly outpaces that of other markets. Growth is expected to be 6.3% in 2019, compared with 6.6% in 2018.
Any improvement in growth will be fragile
Admittedly, the IMF expects an improvement in growth in the second half of the year on account of China’s economic stimulus programme, renewed confidence on financial markets and a gradual stabilisation of crisis-hit emerging countries such as Argentina and Turkey.
However, an unprecedented risk environment will continue to weigh on – and could derail – this potential recovery. The uncertainty surrounding Brexit persists, while trade tensions between the US and its main trade partners – especially China and Europe – are hindering international trade.
According to the World Trade Organization (WTO), global trade is likely to grow by 2.6% in 2019, down from 3% in 2018. In the euro zone, Italy is a potential time bomb, with public debt at 130% of GDP, while impending discussions between Brussels and the populist government could add to market volatility.
Inflation expectations remain doggedly low, and the link between a pick-up in economic activity and inflation would appear to be broken. In Europe, inflation expectations fell to a post-2016 low in May, at just 1.32% – close to the all-time low and some way short of the European Central Bank’s (ECB) medium-term target of just under 2%.
In the US, the core Personal Consumption Expenditures (PCE) index of consumer prices excluding energy and food – the US Federal Reserve’s favourite measure of inflation – remains steadfastly below the 2% mark, coming in at 1.6% in April. This is despite wage growth and the lowest rate of unemployment since 1969. The deflationary forces that emerged during the financial crisis evidently remain at work.
As a result, central banks have had to revise their strategy. In simple terms, it is no longer the time to raise interest rates.
Central banks will have to remain accommodative
In Europe, the uncertain economic outlook and lowering of inflation expectations mean the ECB will be forced to pursue its extremely accommodative monetary policy over the medium term, as ECB President Mario Draghi has made clear. Speaking at the June ECB forum in Sintra, he announced that the ECB stood ready for additional stimulus. This could include further cuts and renewed asset purchases.
At no point could the ECB have raised rates. It is caught in its own trap, not having known how or been able to normalise its monetary policy more boldly when macroeconomic conditions were more favourable than they are today. It is also paying the price for lagging behind the Fed: it launched its quantitative easing programme only in 2015, seven years after the Fed in 2008.
Monetary normalisation in the US, which has already seen nine rate increases, including four in 2018, has also been put on hold. The US Federal Reserve is now under constant pressure from markets and the White House. Having announced a pause early this year, Jerome Powell, the Fed Chairman, is engaged in a balancing act: the US economy – supported by household consumption – is still resilient, and the full employment target has been exceeded.
Nevertheless the June Federal Open Market Committee (FOMC) changed tone from its May statement, indicating that economic activity is “rising at a moderate rate,” a downgrade from “solid.” Mr Powell indicated that he was closely monitoring the impact of the tensions and stood ready to act appropriately if necessary, thus opening the door to a rate cut without explicitly mentioning it.
Demographic and economic factors will keep rates low
There are structural reasons why this period of low interest rates could become more settled over time.
Without getting into the argument about secular stagnation, as advanced by certain economists, potential growth in developed countries – ie, the growth rate that an economy can reach when it fully uses its production factors (labour and capital) without creating inflationary pressures, regardless of economic cycles – is now significantly lower than it was in previous decades.
Ageing populations, low investment levels and an erosion of productivity gains – despite the acceleration in technological progress – are exerting downward pressure on interest rates. Weaker growth restricts investment and ageing populations push up the savings rate. The drop in demand and rise in savings reduce the “neutral” level of interest rates, defined as one that neither stimulates nor limits economic activity.
Another point to consider is that the liquidity ratio – one of the key components of the Basel III banking regulation – requires banks to hold a certain percentage of high-quality liquid assets (HQLA) in reserve, in case of market unrest. As it is, these HQLA are mostly sovereign bonds. With supply limited, largely due to quantitative easing (QE), strong demand for collateral will continue to weigh on interest rates.
Potential growth is down, inflation expectations are low, and the equilibrium interest rate looks set to settle below previous levels on a lasting basis. This is true of the whole curve; with short-term interest rates so firmly entrenched in investors’ minds, the whole of the yield curve structure is affected.
This is a fundamental change of perspective, and investors are seeing a new paradigm in which traditional sources of yield have dried up and yields are even negative in some cases. Bonds with negative yields make up about a third of the total outstanding bonds in the developed world, and more than a third in the euro zone, with Germany and France leading the way. Whereas the level fell in the previous two years, after peaking at $12.2 trillion in 2016, the Bloomberg Barclays Global Aggregate Negative-Yielding Debt Index has increased by more than $3 trillion over the past six months, reaching $12.9 trillion at the end of June.
As a result, investors’ hunt for income is more complicated than ever.
Central bank policy rates
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Franck Dixmier is Global Head of Fixed Income and a member of the Investment Executive Committee at Allianz Global Investors.
Active is: Conducting proprietary research
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