Positive ‘Real’ Interest Rates are a Game Changer! (Part Three)

SUMMARY

• The US is finally exiting the era of negative real interest rates.
• Long-term stock returns are likely to be lower going forward…but our fixed income expected returns are meaningfully better than just a few years ago.
• We think this is positive news for balanced investors, especially those needing consistent cash flow.

(Today is the third part of a multi-part Strategic View series entitled ‘Gamechangers,’ in which we explore the various investment implications of a return to positive real interest rates in the US.)

Congratulations! if you have been alive longer than 15 years, you just lived through the entirety of one of the weirdest, most subtly unsettling eras in market history…and we are not referring to COVID-19, Brexit or even the Great Financial Crisis (GFC) per se. Rather, we are talking about the bizarre decade-and-a half-long period where US interest rates consistently yielded below zero after adjusting for expected inflation

In the US from 2008 to 2022, the Federal Reserve’s fed funds ‘real’ target interest rate – ‘real’ meaning adjusted for consumer inflation expectations over the next year – was consistently negative (see red region of Chart 1, above). This unusual era of ‘Financial Repression’ was, in our view, a by-product of a Fed determined to jumpstart the abnormally low economic growth caused by a series of rolling global economic crises – the GFC, various European crises, and COVID-19 among them. These crises, in our view, were exacerbated by aging demographics in the developed world leading to excess saving and reduced risk appetite… as well as slowing growth in China and various other factors.

Financial Repression – Not A Victimless Crime

The 2008-2022 Fed had its reasons for such extreme measures, in trying to stimulate risk-taking and economic growth in an era where there was often little of either. And by some measures, they succeeded. Over this 15-year span, US large-cap stocks, as gauged by the MSCI USA index, averaged a total return of almost 11% per year. But prolonged negative real rates also, ironically, created a set of perverse incentives that encouraged excessive risk taking for businesses and investors alike.

For companies, ‘negative rates forever’ encouraged excess debt accumulation and investment in projects with dubious potential returns. For investors, we would argue that the recent phenomenon of ‘meme stocks’ and ‘SPACs’ (special purpose vehicles that allow firms to use shell companies to go public, while sidestepping regulatory due diligence) were by-products of this ‘cheap money’ era.

Real rates below zero also have potential negative implications for any entity who owes a lot of money, whether sovereign or corporate. Even though low rates make it possible to service higher levels of debt, they also ensure that debt burdens grow over time in ‘real’ terms, all else being equal. This is particularly a problem for the developed world, as the US, Europe, and Japan are all aging, highly indebted societies to various degrees.

Most perversely, negative real rates penalized savers and anyone on a fixed income – including pensioners, retirees, and the elderly. Negative rates of real return mean that the value of every dollar you keep under the proverbial ‘mattress’ - in a savings account or in cash – is losing purchasing power. To this point, over the 2008-2022 period, the average real interest rate for US 10-year Treasury securities (adjusted for consensus expectations of CPI inflation, one year forward) was -0.66%...hardly a compelling investment.

For investors who were increasingly moving towards retirement during this era, the lack of positive returns available in ‘risk-free’ government bonds forced them into a Faustian bargain: either own a higher percentage of stocks than financial planning frameworks recommended - and risk losing their nest egg if stocks corrected - or watch the value of their low-risk assets get eroded away slowly as living costs increased.

Patient Exiting the ICU – Investor Implications of a Return to Positive Real Interest Rates

The good news is that the US appears to have finally emerged from the dark age of negative real rates (see blue line, Chart 2). Since 2022, the ‘patient’ is slowly emerging from the ICU, as robust US growth and strong productivity is powering the US economy (see Weekly View from 2.27.24, for more on the US economy). This has allowed the Fed to aggressively hike rates over five percentage points, without plunging the economy into deep recession.

The process of weaning our nation off the proverbial ‘painkiller’ of low rates has begun, in our view. Like any recovery, it will be uneven and spiked with periodic episodes of discomfort. One such episode was the inflationary spike caused by supply chain disruptions in the wake of the pandemic… the after-effects of which we are still dealing with today. But overall, we think the world is better off in a more normalized rate environment… and long-term investors should take note of some of the wide-ranging implications of what we believe to be a structural move back to positive real rates.

We see this new positive real rate era as having a profound effect on several of major stock and bond market dynamics. In previous weeks, we have discussed how a backdrop of ‘reflation’ should benefit US energy companies, Japanese stocks, and international commodity-based economies, as well as how greater investor emphasis on balance sheet strength and cash flow should benefit mega-cap technology stocks. (See Gamechangers Part One and Gamechangers Part Two).

In this final installment of Gamechangers series on real interest rates, we discuss major asset allocation implications of positive real rates for balanced portfolios. As a builder of dynamic, balanced asset allocation portfolios, RiverFront cares deeply about this topic...and as you’d guess, we have some thoughts. We see at least three major ramifications for balanced investors through the next business cycle:

1. Potentially Lower Returns From Stocks, with Higher Volatility…
2. …but with Higher Expected Returns on Fixed Income due to Higher Yields…
3. …Leading to Similar Expected Performance for Balanced Portfolios as before, but with Higher, More Stable Cash Flow.

US Stock Volatility Likely to Shift Higher – and Stock Returns Likely to be Lower - Through the Next Business Cycle

In December, RiverFront released its Long-Term Capital Market Assumptions, which are meant to give our views into major asset class returns through the next business cycle (defined by RIG as roughly five to seven years). Our Base Case (which we define as the highest probability outcome, in our view) is that of a mildly ‘reflationary’ US economy – one with a healthy level of economic growth, but also moderately elevated inflation and real interest rates compared to recent history.

Our Base Case return assumption for US Large-Cap Stocks is down somewhat from our March 2023 forecast (Chart 3, below). This is primarily due to higher starting valuations, as markets have rallied strongly since then. Our research suggests to us that higher starting points for stock valuations can lead to lower long-term future returns. We think that lower realized stock returns will also go hand in hand with higher volatility, as volatility tends to be ‘asymmetric’ – meaning that volatility tends to increase more when prices fall than when prices rise by a similar amount.

We think balanced investors – and particularly ones who care about income – should consider using a portion of their portfolio to invest in alternative yield strategies that can turn higher realized stock volatility into higher income. The discussion of these strategies is outside the scope of today’s piece – please reach out to your financial advisor for more information.

This higher stock volatility also suggests to us that active portfolio management – especially one with disciplined tactical shifts and risk-management processes - will be a useful portfolio feature in a world where you can’t just ‘set it and forget it.’ With the help of a financial advisor, a professionally crafted retirement plan can be tailored to investors' needs and risk tolerances. We think a focus on portfolio construction, risk management, transparency, and consistent communication are critical elements in giving financial advisors and their clients the peace of mind to stick with the agreed plan.

Even as our Stock Forecast Moves Lower, our Assumptions for Fixed Income Returns Have Moved Higher with Higher Interest Rates

In contrast to our stock assumptions, our long-term forecast for an aggregate of US bonds is meaningfully higher than just a couple of years ago (see Chart 3, above). This is a function of meaningfully higher yields, which should equate to higher total returns if held to maturity. With the Fed’s uber-aggressive hike cycle of 5 and a half percentage points from 2022-2023, interest rates have quickly ‘normalized’ back towards something approximating average historical yields.

These higher rates suggest to us that higher structural bond yields can start compounding earlier in our forecast horizon, leading to meaningfully higher aggregate total returns. Despite the near-term uncertainty for bond prices due to Fed policy, we think bonds have reasserted themselves as a more compelling long-term portfolio return source for one of the first times since the ‘Financial Repression’ era started. This is a major positive for balanced investors, in our view. Below we demonstrate why, using a simple example.

An Example of Why ‘Normalized’ Asset Allocation is Good News, In Our View

We can demonstrate this with a simple theoretical model, keeping the numbers simple for demonstration’s sake. We continue to believe in the benefits of diversification and cannot help noticing that the long-term risk/return prospects for a balanced portfolio look more attractive to us than they have in a long time. This is in part due to the significant rise in interest rates, and the fact that, over the last 12 months, 10-year Treasury yields have averaged above 4% for the first time since 2007. Importantly, we believe the starting yield of a bond is the key determinant of a bond’s return over time.

Diversified (or ‘balanced’) portfolios, broadly speaking, generate returns from two main asset classes: Equity and Fixed Income. Equity investments generate portfolio performance via the rise (or fall) in the investment’s price and any dividends that the investment pays. Fixed Income investments generate enhanced portfolio income for the portfolio via their yields. In an environment where bond yields have risen dramatically, there is less performance required from the equity portion of a diversified portfolio.

To demonstrate how a diversified portfolio performs, let’s look at a mathematical example using current data. If an investor is seeking an annual portfolio return from a diversified portfolio and is willing to accept some additional risk from the bond portion of the portfolio above that of a Treasury Bond, the Bloomberg US Aggregate Bond Index (or ‘Agg’), which includes corporate and mortgage bonds, is yielding around 5% as of May 11, 2024. Because this yield is higher than in previous years, the returns required from stocks to meet one’s portfolio goals in this example are significantly lower than before. This is especially true for the bulk of the ‘Financial Repression ‘ era, when 10-year Treasury Note yields remained largely below 3%.

When rates are extremely low, stocks must deliver much higher returns to carry a balanced portfolio. The math is simple on a sample portfolio made up of 50% bonds and 50% stocks. For example, if one has a 6% return objective and bonds can return 5%, then stocks only need to return 7% over time (see example in Table 1, above) to meet that objective. But when rates were much lower, as they were during ‘Financial Repression’, the onus was on stocks to produce much higher returns. The table further illustrates different scenarios of what equity return would be required, given varying starting bond yields, in order to meet a stated portfolio objective.

Having the fixed income portfolio of a balanced portfolio carry a larger percentage of the overall return is beneficial to the typical balanced investor, in our view. This is in large part because a much higher portion of bond total return historically is made up of consistent quarterly cash flow (in the form of quarterly coupon payments) than it is for stocks (via dividends). Thus, inherently the cash flow portion of the portfolio return tends to be more stable and consistent, which can be helpful for investors who rely on their portfolios to fund some or all living expenses.

We believe this difference in total return component composition is the reason that the inherent total return volatility of bonds historically is much lower than that of stocks. Across a long-term data set (1926-2023 for US large-cap stocks, as represented by the top decile by market capitalization of CRSP’s US Total Market Stock Index, and 1976-2023 for the Bloomberg US Aggregate Bond Index), we calculated ‘standard deviation’ (the measure of dispersion of a dataset around a mean; a higher number represents higher volatility of returns) for various asset classes. For US large-cap stocks, the standard deviation was approximately 15%; for the Agg, it was much lower at around 2% (source: CRSP, Bloomberg, Riverfront).

Conclusion: The End of Financial Repression is a Return to More ‘Normalized’ Asset Allocation

The end of negative real interest rates – aka the ‘Financial Repression’ era – is good news for balanced investors, in our view. During the Financial Repression era, balanced investors were increasingly forced to move to a higher allocation of stocks, which resulted in greater portfolio volatility. Now, we believe bonds can do more of the ‘heavy lifting’ to achieve the investor’s long-term portfolio return and cash flow objectives. Getting more of your total return coming from fixed income coupons should reduce the volatility of investors’ quarterly cash flow – crucial for many balanced investors on a fixed income, who often rely on portfolio yields to help defray living expenses.

Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Small-, mid- and micro-cap companies may be hindered as a result of limited resources or less diverse products or services and have therefore historically been more volatile than the stocks of larger, more established companies. Please see the end of this publication for more disclosures.