With the last week of July’s 4.0% GDP number and FOMC meeting statement, concern seems to re-emerge that rates will be headed higher in the near-term. The Fed has said that they will keep rates low for a “considerable time” once the asset purchased have been eliminated, presumably by the fall off this year. However, some speculate that there is enough of an improvement in the underlying economy that this move up is coming soon.
It seems premature to say that the 4% initial number in Q2 is a sign of a sustained improvement versus just a bounce back after an incredibly weak Q1, especially with 1.7% of the gain attributed to an inventory build and all of the GDP revisions we have seen of late. And as Yellen indicated this week in the statement, slack and “underutilization of labor resources” remains. Not to mention that the geopolitical risks seem to be escalating daily, be it Russia, Argentina, or the Middle East, which will likely hamper global growth further.
So while it is not clear to us that an increase in the interest rates that the Fed controls is on the nearer-term horizon, the Fed will likely move at some point in the next year or two. But just because the Fed will start to raise rates at some point in the future, that doesn’t mean that we see a big move up in rates across the board, especially the longer maturities (5-30 year Treasuries) versus shorter term rates. There are other forces at work impacting interest rates. One of these major forces we are starting to see at emerge, and we expect to become more of a factor in the years to come, is demographics: with an aging populations, we see the demand for yield-based securities accelerating.
Demographics are destiny and the shift into fixed income from equities is in the beginning innings; rather than the “great rotation” from bonds into stocks as many have argued. The following chart and quote from Morgan Stanley sum it up nicely.1
Published by Morgan Stanley Research on October 8, 2013
Ageing demographics mean regular income, capital preservation and lower volatility are key
We expect that ageing demographics will subdue the strength of this rotation relative to history and will drive convergence between the Retail market and the retirement market. The reduction in equity allocations for the >60 age bracket over the past decade (based on ICI data for the US market) plus the ageing demographic (consultants estimate that within five years nearly 75% of Retail assets will be owned by retirees or those close to retirement) clearly call into question the sustainability and strength of this rotation back into equities. By the end of the decade, the weight of Retail money will be in decumulation phase, as it is in Japan today. We expect that regular income, capital preservation and lower volatility outcomes will be the key focus of this investor group.
Published by Morgan Stanley Research on October 8, 20132
The bottom line is that the “decumulation” phase is just beginning in most developing countries. The statement that within 5 years, nearly 75% of retail assets will be owned by those retired or near retirement is almost shocking. Just how much of the world’s assets are held by retail? Morgan Stanley recently released a report estimating that approximately $89 trillion of investible assets exist globally and of that about 60% is institutional and 40% retail.3 This translates to approximately $36 trillion in retail assets globally. Those at retirement age in all countries don’t care about Ibbotson charts or expected returns. They want tangible income and principal protection.
The demand is also there on the institutional side, with institutional investors now beginning their aggressive move toward LDI (liability driven investing). LDI is being used not only by insurers, but now by the global defined benefit (“DB”) plan market. Keep in mind that defined benefit and defined contribution pension plans encompass a significant portion of that 60% of global investible assets that is attributed to institutions. As equities have soared over the past five years, many of these large DB plans have seen their funding ratios come close to 100%. Originally, our thinking was that these plan sponsors would continue to “game” pension accounting keeping equity allocations high. What we mean is that pension accounting involves manipulation; “expected returns” of asset classes based on historical numbers enter into the way DB plans have to fund their liabilities. Plan sponsors seem to be choosing LDI as a way to “immunize” this liability rather than roll the dice with equities.
LDI is similar to banks running a fully hedged book. When interest rates rise, the present value of pension plan liabilities fall. But of course when rates rise, many bond prices fall offsetting the liability gains. Conversely, when interest rates fall the present value of liabilities rise offset by a gain in bond prices. Ultimately it is expected that the desire for those running U.S. pension plans to match liabilities will encourage “de-risking,” moving away from equities into the fixed income realm. We have already seen evidence of this de-risking globally.4
Published by Morgan Stanley Research on October 8, 2013
For instance, in the United Kingdom, equity allocations have fallen from 68% to 39% over the last decade, and could ultimately fall as low as 10% for defined benefit plans.5
Published by Morgan Stanley Research on October 8, 2013
So the much discussed great rotation from fixed income into equities makes for nice headlines, but the actual numbers look to be far from reality as the demand for fixed income securities heats up globally, including here in the US.
Furthermore, on a yield front, the US looks attractive relative to the rest of the world. Our 10-year is yielding about the same as those sovereign bonds of the likes of Italy and Spain. Which would you believe is a more credit-worthy country? Our rates are more than double those of countries such as German and Japan.6
Fed policy, as well as supply and demand dynamics all pay into actual interest rates. As we look forward, demand for bonds and other fixed income asset classes is coming from both the retail and institutional investor and that demand is expected to accelerate as the trend of de-risking away from equities and into fixed income moves firmly into place. And we are already seeing a strong demand for bonds above and beyond the Fed. For instance, the bid-to-cover ratio for the longer-term bonds has been nearly 3:1 in 2014. So while the Fed may ultimately start gradually taking rates up over the next couple years, we expect the demand for Treasuries and other fixed income securities to remain strong, and even accelerate as demographics become more of a factor. We would expect that this, along with the economic headwinds and global dynamics, will constrain rates going forward.
1 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 13.
2 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 20.
3 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 15.
4 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 17.
5 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 18.
6 Data sourced from Bloomberg, as of 8/1/14.
This article was written by Tim Gramatovich, CFA, CIO & Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD).