Will this too pass or is this a reality for the foreseeable future?
Contrary to the expectations of some of the world’s most respected bond managers, bond prices continue to rise and yields fall to almost inconceivable levels. According to the Financial Times, on July 5th 2016, the yield on the Swiss government bonds with 50 year maturity hit a low of -0.12%.
Think about that – such is the global environment that investors would rather lend their money to the Swiss government for 50 years, knowing they will lose money on the investment. Is this a complete loss of faith in equity markets or are there other realities to consider?
One factor at play is the Basel III regulations that were put in place for European banks after the 2008-09 financial crisis. An important component is the liquidity coverage ratio (LCR) requirement to ensure large banks have enough cash-like assets to ride out short term liquidity disruptions. This is the percentage of assets that need to be in highly liquid instruments such as sovereign bonds or corporate debt to cover net outflows over a 30 day stress period.
According to the Bank for International Settlements the LCR for 2016 under Basel III is 70% but rises to a 90% minimum requirement by 2018. As large banks scramble to meet these deadlines, scooping up the limited sovereign debt issuance in Europe, bond prices soar and yields plummet in lock step. Increased LCR requirements formulated under Dodd Frank for US banks further exacerbate this picture.
So, in addition to the regulatory framework for banks, what other elements are driving this equation? Another key factor is that when central banks artificially keep interest rates close to zero across the developed world, it’s less of a hurdle for the yields to turn negative. It begs another question – why have central banks in the developed world have kept rates low for so long?
Tim Mullaney’s 7/22/16 Opinion piece on Marketwatch.com notes that the first baby boomers born in 1946 became eligible for Social Security in 2008, became Medicare-eligible in 2011 and upon reaching age 67 in 2013 became eligible for larger social security checks. Although not the sole factor at play these dates mirror large drops in the US Labor Force participation rate, which has dropped by 14 million during the Obama presidency.
Related: The Shadow of Manufacturing on Corporate Earnings
The ageing baby boomers have been a demographic drag for the entire developed world. They were a catalyst for bull markets in the 1980s and 1990s as many got married, had children and acquired larger homes, cars and other significant forms of consumption. However, as the boomers age and become empty nesters they have downsized homes, cars and several other aspects of their spending.
Accordingly, even central bank initiatives offering money at very low rates may not be enough to compel them to spend or invest. As a result, the developed world seems mired in a period of anemic growth absent more individuals to offset the boomer consumption decline. This shortfall may be difficult to reverse in the near term.
Greg Ip’s “How Demographics Rule the Global Economy” article in the Wall Street Journal (from 11/22/15) notes that 2016 represents the first time since 1950 that the combined working-age population of developed nations will actually decline. By 2050 the United Nations projects this figure will shrink by 5%. It becomes increasingly difficult for economies to grow and equity markets to rise when there are less employed people to drive that growth.
Even initiatives to boost birthrates may not be sufficient as the positive impacts may be a generation away. While there are no uncomplicated answers to this clear trend, one of the options to stimulate growth is to add people via immigration from developing nations. This may present a host of cultural, linguistic and possibly religious challenges and is not without controversy.
Related: Are Interest Rate Hikes ‘Back on the Table’?
The Guardian newspaper pointed out in its 8/22/15 “Europe needs many more babies to avert a population disaster” article that the German government expects their population to plummet from 81 million to 67 million by 2060 based on current birthrates. Accordingly, they would need 533,000 immigrants annually just to maintain the current population level. This likely provides context as to why Germany accepted an estimated one million Syrian refugees in 2015 and hundreds of thousands more this year.
With no near term solutions to the demographic drag on growth, central banks are likely to keep interest rates lower for much longer in order to entice an aging cohort to spend or invest more. As rates remain low, and corporations struggle to sustain both the top and the bottom line, the relative appeal of bonds could conceivably increase. As a result, negative long term yields may be a reality for the balance of the decade and possibly longer.
Hafeez Esmail is the Chief Compliance Officer at Main Management, a participant in the ETF Strategist Channel.
A pioneer in managing all-ETF portfolios, Main Management LLC is committed to delivering liquid, transparent and cost-effective investment solutions. By combining asset allocation insights with smart implementation vehicles, Main Management offers a unique approach that translates into distinct advantages for our clients, including diversification, tax awareness and cost efficiency. For more information, visit http://www.mainmgt.com