The Implications of an Ultra-low Yield World

The Implications of an Ultra-low Yield World

This quarter’s newsletter addresses two issues; large cash balances in client accounts and the challenges investors face in an ultra-low interest rate world. Before discussing what lies ahead, here’s a quick a review of 2019 performance.
In the first nine months of 2019 (if MCS clients’ investments were treated as one large portfolio including their cash), clients gained 4.11%¹ on average, after fees. For comparison purposes, the S&P 500 Total Return Stock Index (S&P 500) gained 20.55%, and the Barclays Aggregate Bond Index gained 8.52%. The range of MCS individual client returns was from a gain of 0.30 % to a gain of 8.93%. These results represent the flip side of a defensive strategy; you don’t make as much as investors who took more risk.

MCS Client Cash Balances Highest in my 36-year Career

If you’ve looked at your Schwab statement, you have noticed that cash balances are now a very large percentage of your portfolio. This is my investment decision, and it is based on the lack of attractive risk-adjusted investments available in the market. As I write this, the yield curve is inverted, meaning short term rates are higher, or nearly as high as, long-term rates (see Figure 1). The orange line shows interest rates on September 30, the green line on October 18.

As interest rates have shifted, bonds maturing in less than a year (which includes money market funds) now offer higher yields than many longer-term securities, and for a fraction of the risk. This is what active management looks like; finding clients the best risk-adjusted return given the available investments. After US Treasury Bills (T-Bills) I purchased for clients mature in October, many clients will find their money market balances even larger. It has been difficult to find attractive short-term bonds, and by “attractive” I mean bonds offering enough extra yield to compensate for the additional risk, liquidity, and tax advantages of T-Bills. By November of last year, interest rates on the 10-year US Treasury Bond (T-Bond) had climbed to over 3%. Cash equivalents (investments maturing within a year) were the only assets that had a positive return in 2018. As T-Bond interest rates rose I began feeling that, at long last, investors would finally get an opportunity to invest at attractive yields in relatively safe, risk-compensating securities. The higher yields were very short lived. As the trade war increased recession fears, and long-term bond yields began dropping in response, the Fed announced it would cut interest rates. Up to then I had been playing defense, concerned about the negative impact of higher rates on the value of your portfolio, as occurred last year. MCS clients’ performance squeaked out a small positive return last year.

Events this year, however, demonstrate that we also need to prepare for a very long period of low bond yields. It may seem confusing that last year I was concerned about higher rates, and this year I see persistent lower rates as a problem, but we are in a place where either outcome will hurt investors. Higher interest rates from unexpected inflation, or a prolonged period of ultra-low interest rates, are both very bad news for savers. Previous newsletters have discussed the risk of higher rates (which played out last year), so this newsletter discusses the risks of a long period of very low interest rates.

What Got You Here, Won’t Get You There

US Interest rates have been falling for 37 years (Figure 2), and they are likely to continue to fall until rates on 10-year US treasury bonds are negative. I’m going to offer a big picture view of how we got here and the implications for the future. As you can see in Figure 2, interest rates peaked in the early 1980’s and have been declining ever since. Today rates are lower than at any time in the past 57 years. With the benefit of hindsight, the boomer generation and their parents have been two big demographic cohorts of lucky ducks. Falling interest rates over the past 37 years have created a tremendous tailwind (present value effect) boosting the value of real estate, stocks and bonds, which in turn boosted investors’ net worth.

I am not ignoring factors like economic growth, demographic trends, stock buybacks, etc., but I want to impress upon you the present value effect of lower interest rates is a major contributor to the higher asset prices we see today.

How Do Ultra-low Rates Affect You Long Term?

The falling interest rate tailwind has all but petered out, and interest rates will likely end up in negative territory in the next recession (if not before). Negative yields mean that investors pay the government when they buy government backed debt, rather than the government paying them. Investors are getting back less money than what they invested, and that doesn’t even take inflation into consideration. While that may sound crazy, negative interest rates on 10-year government bonds are as follows: Japan (-.14%), Germany (-.41%), Switzerland (-.45%), France (-.37%), Sweden (-.55%) and Netherlands (-.43%). To take Switzerland as an example, that would mean investing $10,000 in government bonds today and getting $9,559 back after ten years, or $9,183.45 adjusted for a 0.4% annual inflation rate.

If a Japan-like ultra-low interest rate environment for US investors persists for many years, the strategy that I have employed successfully on your behalf throughout my career is dead.

The MCS strategy has been to allocate (70% plus or minus) to longer term (5 to 15 year) investment grade bonds to create a reliable stream of cashflow. The rest of the portfolio is allocated between cash and stocks. The heavy emphasis on earning interest and repayment of principal at maturity allowed clients to ride through past financial crisis with ease and a great sense of security. It provided steady continuous compounding of your money and predictable cashflow. This strategy, to produce reliable cashflows to meet retirement income needs, is similar to how insurance companies and many pension funds invest (or did at one time).

Persistent rock bottom interest rates on safe investments are an unmitigated disaster for savers, worldwide. Watching the Fed’s and market’s reaction to events that have unfolded over the past year or so, I must conclude that clients should be prepared for a scenario of near zero interest rates on long term government bonds for years to come. This scenario would profoundly impact most investors. My gut probability that a prolonged period of low interest rates comes to pass: 60-70%.

If you have a pension, you are better off than most, but you should not count on receiving all the benefits promised. A
recent Bloomberg article illustrates the case (emphasis added):

“All across corporate America, underfunded pensions have become the norm. Even now, a decade after the financial crisis, the largest plans face a shortfall of $269 billion, right about where it was 10 years ago. Years of low interest rates have largely offset gains in the stock market. Companies haven’t helped matters by lavishing money on shareholder rewards and clinging to assumptions about returns that proved to be too rosy.²”

“Using higher projected returns lowers the money (an expense) the plan sponsor must contribute. It lets them report higher earnings” Warren Buffet warned in Berkshire Hathaway’s 2007 annual report. And if they’re wrong, “the chickens won’t come home to roost until long after they retire.”

Public pensions play the same game; underfunding contributions and over-estimating future returns. ‘Kicking the can down the road’ on plan funding issues allows them to stay on budget and minimize criticism by both plan beneficiaries (You promised!) and taxpayers (My taxes are too high now!).

What if you don’t have a defined benefit pension plan but have a defined-contribution plan (401k, IRA, SEP or profit-sharing) instead?

The deck is stacked against you compared to those with traditional pension plans. Those saving for (or in) retirement using 401k / profit-sharing plans are much worse off. There is no backstop like added employer contributions in a pension plan to make up for funding shortfalls in a 401k/ Profit sharing or similar plan. Defined contribution plans have significant limits on annual contributions and even in the rare situations where the plan participant has the money to make a larger contribution, they can’t legally do so.

Large pension plans have another advantage over individuals saving for retirement. Pension plan retirement benefits are typically spread over many, many decades. This provides time diversification; pension payments will be distributed over many investment cycles allowing the plan a better shot at earning the long-term return of the asset class they are invested in, thus reducing the impact of a period of poor investment returns. An individual saving in a 401k has no time diversification advantage. A 401k participant is going to retire at a certain point in the investment cycle and they are stuck with what follows.

What Follows: Lessons from Japan?

A recent Bloomberg article discusses the failure of ultra-low rates to boost Japan’s economy and importantly lands on a central theme of this newsletter: US Investors saving for, or in, retirement are in trouble and don’t yet realize it.

Quotes from the article sum up the problem:
“For now, Japan’s problem is unique, but if low rates are prolonged, which I think they are likely to be, this will be a serious challenge for the U.S. and other nations,” Kanno³ says. “The bottom line is that the global economy is facing the question of how we are going to live” without interest income on safe assets such as government bonds.
“The paltry returns represent a very real threat to Japan’s population of pensioners…” BOJ Governor Haruhiko Kuroda has warned. Figure 3 starts at the last time Japanese 10-year bonds yielded about 2%⁴

Interest rates on 10-year Japanese government bonds since 1998

Japan has the longest experience with ultra-low and negative interest rates. On 12/31/1998 the interest rate on the Japanese government 10-year bond was 2.22 %, and it has not been higher since. Stock returns since 12/31/1998, including reinvested dividends, have averaged a measly 3.72%. While I would agree that the US is not Japan, and that Japan is the only example of an economy that has had a long period of ultra-low rates, the experience of Japanese stock investors during the past 20 years should give US investors pause.

What about stocks in an ultra-low rate environment?

US based advisers love to talk up the benefits of long-term stock investing using US historical data as support. What concerns me is that US historical data may have little relevance, or be entirely misleading, when the future is comprised of outcomes with little historical precedent.

Historically (1926-2018), the average annual return on US stocks is roughly 10%. In the current environment, I’d estimate a more realistic long-term return assumption for US stocks is 4% to 6%. A total return on US stocks of 5% may seem too low, and yet it would very look good compared to the 3.72% return on Japanese stocks since 1998, the last time rates were above 2% on 10-year Japanese government bonds. Assuming a 2% bond yield and a 50/50 allocation to Japanese bonds and stocks 20 years ago would produce a total return of 2.86% before management fees.

If Japan’s twenty-year stock returns in an ultra- low interest rate environment are any indication, the return on buy and hold stock index investing will be a gut-wrenching disappointment for those with return expectations near historical averages.

Figure 4, below, shows the returns on Japanese stocks, including and excluding dividends, after interest rates on the Japanese 10-year bond dropped below 2%. For 15 years of the 20-year period, the market went sideways.

I use Japan as the longest real-world example of what an ultra-low yield world can look like for investors, and the pressures this can put on pension funding (whether for individuals or pension funds). German 10 year bonds entered the sub 2% yield world in late 2011. It’s reasonable to assume the US will follow. As I was writing the newsletter, I found many articles that address the implications of a low return world on pension funding. A sampling of titles speaks volumes:

• GE Unfunded Tab Is Just Tiny Part of Companies’ $269 Billion Gap 10/09/2019 Bloomberg
• A $440 Billion Pension Market Sounds Alarm as Liabilities Swell 10/07/2019 Bloomberg
• GE to Freeze Pensions for 20,000 Workers WSJ 10/07/2019
• Pension Funds Sink Billions into a Whole New World of Risk 10/02/2019 Bloomberg
• Investors Scramble for Yield as Growth Outlook Darkens; Some need to take more risk or lower longer-term
  expectations WSJ 09/30/2019

• Corporate Pension Funding Moves Closer to Worrisome 80% Level 09/09/2019 Bloomberg
• Pension World Reels From ‘Financial Vandalism’ of Low Yields 08/27/2019 Bloomberg

What are Your Investment Alternatives in an Ultra-low Yield World?

• Accept low returns, count your blessings and, if need be, adjust your life accordingly
  • Doesn’t sound like fun – go to www.globalrichlist.com⁵
    for some perspective.
• For an undefinable period of time, accept lower and safer returns until a new financial crisis creates better buying opportunities
  • It’s easy to say, but very hard to execute. Fear is contagious. No one rings a bell at the bottom of a market.
  • For example, our buying during the municipal bond crisis (2009-2011) is what put investments yielding 6 to 9% in client portfolios. Many clients were very uneasy about my bond purchases during the crisis.
• Take more risk with no assurance it will work out as hoped
  • This what large pension plans have been doing. Unfortunately, despite their size, negotiating power, and access to deals an individual investor can’t get, their returns have fallen well short of their assumptions.
  • Many advisers recommend ‘alternative investments’. There are many reasons I don’t buy them for clients.
• Find another adviser that believes a better story about the future, invest accordingly, and hope they are right
  • Advisers are trained to use the past to predict future returns. You will have no problem finding a better story because the last ten years have been a steady bull market. – This generally involves taking more risk (see preceding bullet).
• For those still working: save more / spend less
  • Not fun but it’s something you can control, unlike the financial markets.
• For those near retirement: Be mindful. Stress test your portfolio. Being debt-free is good.
  • Investment risks haven’t changed but the potential to recover from significant losses is now much lower.
• Fire me to save money and do it yourself
  • Weigh the trade-offs vs. your time, enjoyment, knowledge /cost of not knowing.
  • There are worse outcomes than making very low returns.

What Is “Enough” in an Ultra-Low Return World?

Enough is both subjective and objective. A monk, having taken a vow of poverty to live a more contemplative life,
will have a different perspective on ‘enough’ than the typical “1%’er” will. The chart below categorizes different
financial situations and offers some perspective. Before using the table, here are some observations to keep in mind:

• Those with ‘more than enough’ often worry they have ‘not enough’ which is why they have ‘more than enough’.
• ‘More than enough’ and ‘probably enough’ is not solely defined by ‘how much’ you have, it’s based on your
  relationship with money. Do you live within your means, which includes adequately saving for the future?

• ‘Not enough’ is based on your relationship with money, your age and lifestyle expectations.
• It’s possible to move in any direction from one category to another.

What Constitutes Enough?

Here is way to do a ‘Back of the envelope’ estimate of ‘Enough’:

1. Determine accurate annual expenses minus social security and any other regular payments (i.e. pension).
   These are your net annual expenses.

2. Divide your net assets (total assets minus debt, including your home and your mortgage) by net annual
   expenses. This gives you the number of years the money will last.

3. Add those years to your current age to get the age that your money runs out.
4. More than Enough: If the age your money runs out easily exceeds your life expectancy, you have more than enough – provided you don’t lose it.
5. Probably Enough: Money runs out close to your life expectancy – provided you don’t lose it.
6. Not Enough: Money runs out well before your life expectancy.

Why use a simplistic ‘back of the envelope’ calculation for something so complicated and important?

The advantage of the simplistic method is that it’s easy to understand, and its limitations are obvious. For decades, when doing retirement planning, we’ve used more sophisticated methods like Monte Carlo analysis combined with intensive modeling that includes inflation estimates, historical data, alternative scenario analysis, and alternative asset class correlation assumptions. The apparent sophistication of these process hides the output’s fragility.

Every assumption has some error in it. When a lot of assumptions are put together to derive outcomes, the estimating errors are increased. In addition, there are assumptions (for example, in Monte Carlo modeling or investment return forecasting) that don’t exactly conform to the real world. Modeling approximates how the world works. If you know these issues, you can work around many of them. In the past, we worked around these limitations by using a large portion of bonds, because the predictability of bond interest and principal repayment offers an antidote to many of the measurement errors and assumptions used in retirement plan modeling.

What to do Now

The next step is to ask whether a long period of ultra-low returns makes a difference in your situation. The place to start is with a ‘back of envelope calculation’ of how long your money will last.

Would you like MCS to help you with the ‘back of the envelop calculation’? We will at no charge. Please call or send an email to jeff@mcsfwa.com or michael@mcsfwa.com with “Back of the Envelope” in the subject line.

Errata: Many thanks to our client, Russ, who spotted an error in a chart in our previous quarter’s newsletter.
We have since corrected and updated the second quarter Newsletter. Please let us know if you’d like the updated
version.