Income investors have now suffered for nearly a decade under a regime of near-zero interest rates.
Last week, European Central Bank President Mario Draghi intensified his version of this policy by lowering the ECB base rate to minus 0.4% and announcing a system of loans to banks at negative interest rates.
For income investors, this is yet more bad news. These changes reduce the absolute yields available and make the system too unstable for long-term strategies to work properly.
The direct effect of ZIRP (zero interest rate policy), which in Europe has become NIRP (negative interest rate policy), is clear – indeed intentional. By keeping short-term interest rates so low, policymakers hope that long-term rates will follow suit.
Ten-year Treasury bond rates fell from a peak of 4.1% in June 2008 to a low of 2.42% in December 2008 – a normal effect of that period’s financial collapse and deep recession.
However, after rising to a peak of 3.85% in April 2010 as economic recovery took hold, rates have since been forced downward by the Fed’s aggressive monetary policy. In February 2016, 10-year Treasury rates averaged 1.78% – lower than at any point in history before 2012.
While investors in long-term bonds initially enjoyed a nice capital gain from declining interest rates, they’re now getting an inadequate income unless they take a lot of risk. In addition, they’re running the risk of massive capital losses as interest rates revert to normal levels and bond prices decline.
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To add insult to injury, there’s a further hidden risk to “funny money” policies.
You see, stimulative monetary policies boost asset prices – indeed, it’s one of the principal attractions. And for the very rich, that’s great. They can borrow at very cheap rates and buy assets, thus becoming even richer.
That’s why hedge funds and private equity funds have proliferated in the past decades. It’s also the basis on which Donald Trump has built his fortune.
But for ordinary income investors planning for retirement and trying to put their money in solid investments that provide a decent yield, it’s very bad news.
Assets that have risen in price far beyond their replacement value cause a frenzy of deal-making and leverage, which is exacerbated by the speculative funds. This naturally causes a series of financial crashes in one asset class after another, which makes the overall financial system much less stable and makes otherwise solid assessments of value utterly irrelevant.
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Thus, long-term-oriented investment strategies no longer work in a funny money environment.
The only way you can make money is by jumping from one asset class to another, hoping to ride the elevator as high as possible and then jumping off before it crashes down again.
Investment then becomes a roller coaster, and even the most clever and connected investors can’t hope to make money on a consistent basis – as witnessed by the recent poor performance of Bill Ackman’s Pershing Square fund, which suffered its worst year in history in 2015 and has suffered still more losses in the first few months of 2016.
Obviously, income investors can’t play this game. We’re looking for holdings that pay a steady dividend, year after year, ideally with some increases to keep us ahead of inflation. That’s not something the present market offers.
If we have to change our investment strategy every few months to match the market’s booms and busts, how can we establish a steady and increasing income for our retirement?
The other problem income investors face today is that of increasing overvaluation. If you take the Dow Jones Industrial Average value of 4,000 in February 1995 and adjust it for the increase in nominal GDP since then, you get around 9,000, which is barely half the current level.
Corporate profits are a higher share of GDP than they were in 1995, but that too is a trend that could reverse. Thus, income investors buying stocks in today’s market face the prospect of a major price reversal that will devastate the value of their portfolios.
After the crash, yields will be decent again, but investors may have only half their original capital with which to buy.
One solution to this conundrum is to diversify geographically.
Europe and Japan have especially dismal growth prospects currently, but emerging markets offer better growth prospects and an environment less distorted by a decade of funny money.
While emerging market dividends often suffer withholding tax at source, if held in a taxable account, the tax withheld can generally be offset against other U.S. taxes.
In a global market crash, emerging market stocks will also suffer, but they’ll recover quickly (as they did in 2009), and their underlying economic growth will cause dividends to grow in tandem.
Bottom line: Income investors aren’t dreaming when they think their problem is currently tough. Only with reformed monetary policy will it get easier.