Independent Thinking^®

Navigating Low Yields and High Asset Valuations

We have been living with near-zero interest rates for so long that they are beginning to feel almost normal – but they are not.
 

Distinguishing between artificially inflated assets and those of real value will challenge investors through 2017 and beyond.
 
The world’s major central banks have deliberately boosted the price of financial assets, in an unprecedented effort to increase investment and economic growth. While they succeeded in increasing the value of financial assets across the board, the real economy is not feeling the love. U.S. real GDP is growing at an annual rate of only 2%, and real income has been stagnant by some measures. However, it should be noted that because the recovery and expansion have been relatively long – and are expected to continue – the cumulative growth of the economy since the financial crisis is respectable.
 
Low interest rates have also given governments license to pile up debt, while harming banks’ earning power and punishing conservative savers. For instance, the amount of U.S. government debt held by the public has more than tripled since 2000, and yet interest costs of about $250 billion per year have held steady, due to the dramatic drop in interest rates. A significant increase in interest rates would put pressure on future federal budgets. The federal budget deficit would increase by about 3% of GDP if interest rates suddenly moved back to levels that prevailed before the crisis.
 
At best, the reach for income flows from high-quality assets will support asset values as the central banks slowly ease up on the gas. At worst, the central banks will discover that they have run out of ammunition to combat future recessions. If we were to enter a recession at or near current interest rate levels, the Federal Reserve will only have two options left – negative interest rates, which so far have not demonstrated efficacy in Europe or Japan, or so-called helicopter money, which is the final frontier. (Helicopter money refers to the Fed directly funding federal government deficit spending and/or extinguishing some of the government debt held on the central bank’s balance sheet.) Although we do not expect a recession in the near term, it is impossible to judge when the markets might start to lose confidence in the central banks and price down assets accordingly.
 
In the interim, slow but steady economic growth coupled with zero interest rates continues to drive up the value of perceived high-quality, stable income flows. The higher investor confidence that the income flows will continue undiminished, the higher the valuation. So the sovereign debt of the most stable economies has become the most highly prized asset, followed by high-quality corporate and municipal debt. Next on the list are top-quality, income-producing real estate (Class A buildings in gateway cities) and large, stable, dividend-paying stocks (utilities, food packaging and REITS). Investors are now willing to take on equity risk or illiquidity to capture future income, even if there are little or no prospects for growth.
 
While relatively expensive, these asset classes should not be completely avoided. They will continue to be the preferred investments should zero interest rates persist and should the U.S. economy slow further and begin to resemble those of Europe and Japan. However, it is equally important that investors diversify away from the currently favored assets and find pockets of reasonably valued investment opportunities that should not be harmed when and if we return to more normal interest rates. These include direct investments in unsecured consumer and small business loans (see Stephanie Hackett’s article on page 10), and illiquid middle market leveraged loans.
 
The illiquid private equity and private real estate sector are very inefficient relative to the public markets, meaning that the spread between the returns of top-performing managers and average returns are large and persistent. This suggests that first-quartile performing managers should produce attractive returns, even in an environment of generally falling asset values due to rising interest rates. We are recommending that qualified investors allocate approximately 10% of their portfolio to illiquid assets; a higher allocation may be appropriate depending on each client’s individual circumstances and goals.
 
We remain focused on building all-weather portfolios that can achieve our clients’ investment objectives, striving to preserve and grow their assets to produce the best possible risk-adjusted, fee-adjusted returns. No one can predict the future, but we can chart a course to withstand a wide range of possible outcomes.
 
John Apruzzese is the Chief Investment Officer of Evercore Wealth Management. He can be contacted at [email protected].