What to buy as interest rates sink to zero

JPM looks at the history of asset allocation in other countries using the US as example:

 The steady fall in UST yields, despite a strong economy and a large deficit, raises the prospect that the US could join the zero bond yield world of Japan and Europe in the next few years.

 ECB and BoJ have effectively fallen into a liquidity trap where extra liquidity has little impact given a weakened financial sector, the zeroyield bound, and backward-looking inflation expectations.

 Market performance for Japan, Euro area and Switzerland over past decade is instructive in building a asset allocation for USD investors concerned about the risk of the US joining the zero-yield world.

 Against our priors that a collapse in bond yields to zero should create massive asset price inflation, we find that it had no impact on credit spreads, earnings yields or dividend yields. Perplexingly, Japanese and European households have not abandoned bonds. We did see higher house prices, slightly weaker currencies and financials’ underperformance.

 During the Entry into a low-yield world, US investors should be long duration, be short the dollar, and initially underweight risk assets.

 During Life in a zero-yield UST world, investors should significantly overweight Credit and Equities, and higher-income securities among them, including REITs, high-dividend stocks, HY, and EM local debt, currency unhedged. Avoid Financials, Commodities, and TIPS.

The above return implications mean that a USD-based investor, wary of the UST market moving towards a zero yield, should initially combine an aggressive long in duration, through US Treasuries, with an underweight in risk assets, credit and equities, as the latter will suffer from the deflationary shock, like a recession, that pulls bond yields below 1% in their way to zero.

Beyond this initial deflationary shock, and well before UST yields hit zero, risk assets will rebound and one should similarly go long risk assets. Relative to a normal cyclical rebound portfolio, in this scenario investors should stay long duration, pretty much until the full UST curves is flat around zero. Within equities, one should favor sectors and styles that are income oriented and gain from lower bond yields. That means highdividend stocks and REITs, against Banks and Insurers. We would be overweight Value, Small Caps, Minimum Vol and Momentum also, although that is not related to any view on bond yields. Gold and other Commodities should be underweight as they yield no income and are more attractive in a rising inflation environment.

Once UST yields reach zero, one ought to abandon safe bonds given their lack of return. However, this does depend on what kind of volatility regime they reach. If the Fed pursues a BoJ type of yield targeting, then UST volatility will collapse and these bonds will lose any diversification value against riskier assets. If the Fed pursues instead a more ECB like policy, UST vol might not fall that much. USTs would retain some diversification value and could receive positive allocations despite their expected zero long-term return. In our optimization, we use lagged vols and correlations for the last 30 years as per data availability, during which time UST returns had a slightly negative correlation with SPX returns. Risk diversification showed up most in the allocations to HG.

What to do with EM? In our LTS on EM and on Deglobalization, we argued that EM Equities will outperform if their economies can accelerate against DM. They were able to do this in the past through globalizing their economies and thus importing superior productivity from the DM economies. The globalization process stalled this decade, pulling EM returns down against DM. The rise of populism and the great-nation conflict between the US and China point to a significant risk of de-globalisation over the coming decade.

Trade is not the only way to boost growth. Domestic reform and improved governance can do the same trick, However, outside China and maybe India, we do not see serious structural growth plans among EMs. If anything, the forces that are bringing real yields down in the world likely include low productivity growth and thus a low demand for capital, not a world in which we would expect to see stronger growth in EM. Hence, we do not see much of a case to overweight EM equities in our zero UST yield world.

Can’t the case be made that as UST yields head to zero, the same search for yields that brought capital into the US from zero-yielding Europe and Japan will bring a tsunami of capital into the better-yielding EM local bond world? To get the superior yield from EM, DM investors would have to hold the bonds currency unhedged as hedging would over time eat up the extra yield. If the inflow is substantial enough, then EM currencies would rally against the dollar and USD based investors would collectively gain the most from investing unhedged in EM local bonds. That is what will probably happen.

It could be countered here that during the past decade of zero yields in Europe and Japan the yield attraction of EM local bonds did not pull in enough capital from DM to offset the negative impact of disappointing growth and thus allow EM currencies to rally. However, this is only true from the dollar point of view. From a euro and yen point, EM currencies gained 2.7% and 1.9%, respectively, over the past 10 years.

The shock of zero bond yields on USTs is likely to elicit much stronger flows into EM than those coming from Europe and Japan, both because this time there will be no hiding elsewhere in DM and because the dollar bond market is so much larger. Hence, after the deflationary shock that triggered the slide in UST yields has passed, a USD based investor should strategically OW EM local bonds, currency unhedged. We have argued above, in footnote 5, that there is an independent case to see a significant probability that Chinese rates and yields might reach zero before the US, thus strengthening the case for a long duration position in EM bonds. In the case if China, we would currency hedged the position, though.

That looks like a pretty good assessment for Aussie investors as well.

Houses and Holes

David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the fouding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.

He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.

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