Permanent Value

Week in Review 10/28/13

Bruce Doole
October 28th, 2013

How to Prepare for a Rising Rate Environment

After years of historically low interest rates, driven primarily by a period of sustained central bank quantitative easing policies, we now find ourselves in an environment where those policies are being scaled back and interest rates appear headed toward more historic norms. The real question is, what does that mean? While opinions differ, many in the fixed-income group at American Funds believe any impending rise in rates — and the corresponding drop in bond values will be more moderate and perhaps less volatile than in past cycles.

There are a variety of reasons for this thesis. Portfolio manager and quantitative analyst Wesley Phoa recently outlined his thinking on the topic and identified five reasons for a steady but more subdued rise in interest rates.

1. Demographics are different: We have an older population in the U.S. and in almost all developed countries than we did before. That may mean proportionately bigger demand for retirement income today or in the near future, more risk aversion among investors, and possibly lower GDP growth because fewer young people are ramping up their skills and preparing to enter the workforce. This is all consistent with lower interest rates/lower bond yields.

2. Higher unemployment and a changing global economy: With higher structural unemployment and a deterioration of skills among workers, there seems to be some shift in productive capacity and growth away from developed countries like the U.S. into other parts of the world. I think there are reasons to be optimistic about the U.S., less so Europe, but it is something we need to factor in.
3. Regulation: Changes in financial regulations mean large financial firms are forced to own bonds, especially government bonds, much more than in the past. So there’s a structural demand that didn’t exist before. This likely leads to a lower bond rate than before.

4. Large retirement (defined benefit) plans: Having had substantial equity holdings for a while, these plans are in the process of shifting from equities to long-term bonds over the next few years. So if a plan today is about half in equities, we’ve spoken to many plans that say over the very long haul they are targeting 80-90% or more of their portfolio to be placed in longterm bonds. The more rates go up, the more incentive they have to do this because they can generate more income for retirees.

5. Inflation: Inflation is structurally lower than it used to be, and inflation risk — the risk that inflation might substantially eat into income generated from bonds— is structurally more contained than it used to be. Our outlook for inflation right now is very low. Over the long haul, it’s probably not lower than it was in the 2000s, but probably lower than it was in the ‘80s and ‘90s. There’s definitely some risk around that forecast of inflation getting high and variable, but we’re not talking about the same inflation risks as in the late ‘70s and early ‘80s.

 

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