Iggo's insight - The opportunity set

The opportunity set

Investors are rightly concerned about the coronavirus. We don’t have the ability to judge how long the epidemic will last and how bad it will get. In the short term this uncertainty is hitting markets and ensuring January ends on a significant risk-off note. This won’t do much for investor confidence, especially in Europe where the prevalence of negative interest rates is seen as a major headwind to investment returns. It needn’t be as we have seen in recent months. Since the euro was created, there has been a wide range of investment return outcomes at all level of official interest rates – even since the ECB broke the lower bound. This will continue to be the case. Economic growth, inflation and shocks will be the determinants of returns, not the level of rates itself. Investors have the choice of no return cash or taking a long-term view and exposing their savings to coupon and dividend return and active management. Markets won’t stay still just because the ECB does.


There is little doubt that investors today are more aware then ever of the presence of central banks in financial markets. Vast quantitative easing programmes over the last decade and the crossing of the zero bound for interest rates have given rise to lively debates about, and serious research into the role of monetary authorities. Some commentators blame central bankers for creating financial instability, others welcome the monetary policy actions taken in recent years for the role they have seemingly played in avoiding financial and economic disaster. It is not uncommon to hear people suggest that potential returns from investing in the financial markets have been eroded by the fact that interest rates are so low, while simultaneously hearing that the reason returns have been so strong is because interest rates are so low and central banks are pumping money into the markets. One could take this to mean that there is a point at which central bank activity stops being a source of high returns and becomes a reason for low returns. In reality, that point has not been reached and I am not sure that it can be. The level of interest rates is not an impediment to positive returns from financial markets.


Investors, especially in the bond market, often argue that they can’t get adequate returns from fixed income because rates are too low. This is at its most extreme in Europe and Japan where negative central bank rates prevail. However, it is an argument raised in many geographies. Low central bank policy rates combined with quantitative easing have driven down yields on existing debt and allowed new debt to be issued with increasingly lower coupons. Total return is too often seen as being only determined by the prevailing level of yield. That is true of course for strategies that buy bonds and hold them until the mature, but not for strategies that actively manage bond exposures. The most vocal pessimists will also argue that returns will be even worse once central banks stop supporting the market as it will lead to an increase in rates and negative returns in bonds. That is a truism, but it doesn’t mean it is going to happen any time soon. Furthermore, if it did, one has to understand the dynamics of fixed income to realise that this would not be a permanent state of affairs. I have stated many times over the years, bond bear markets don’t last that long. Long-term investors should be able to look through adjustments to the yield regime and build portfolios that navigate that transition accordingly.

Returns lower with negative rates, but not by much 

I did some number crunching this week. Focussing on the Euro market, I looked at the returns from various asset classes under different ECB interest rate regimes since the euro was launched twenty years ago. For a number of assets (using index returns) I looked at the average and the range of daily returns at every single level that the ECB’s discount rate has been at since the single currency was launched. That range is from 3.75% down to the current -0.5%. The distribution of returns varies at different levels of policy rate, but not by as much as some might think. Generally, the average daily total return for index returns in German bunds, Italian government bonds (BTPs), Euro investment grade and high yield corporates and European equities were higher when the ECB’s policy rate was positive compared to the period since 2014 when it has been negative. However, the differences are not huge. The average daily return from European equities during the period of positive rates was 16.6 basis points. Since rates have been negative it has been 14.5 basis points. Of course, over time these differences compound to be quite material. Annualised rates of return have been significantly lower during the negative interest rate regime for all asset classes compared to the entire period of the euro’s existence.    

And still plenty of opportunity

Yet there is still a material distribution of returns at each interest rate level that supports active investment management. The standard deviation of daily returns at each interest rate level has been pretty similar for German government bond returns, European investment grade corporate bond returns, inflation linked bond returns and Italian government bonds. Where there has been a material reduction in volatility it has been in European high yield and equities – the riskier asset classes. This has had the effect of improving the average risk adjusted return profile for riskier assets. Thus, negative rates have indeed improved the quality if the not the quantum of returns from asset classes that are more exposed to the real economy compared to those more exposed to interest rate risk. This is what unconventional monetary policy is supposed to do as more stable returns should attract more investment into the real economy through corporate borrowing and equity participation.

It's not the rate level, it's what's behind it 

Actually the best period for risk-adjusted returns for all asset classes in my little study was the period when interest rates were set at zero. Here’s the rub. It’s not actually the level of interest rates that dominates the return profile. It is the factors that explain why interest rates are at those levels. Rates being at zero was not itself a reason why returns were good it was the fact that the reduction in rates to that level was the point at which then ECB President Draghi promised that he would do everything possible to save the euro. You could possibly argue that the market reaction – very strong – would have been the same if rates had been cut to 1% or -1% as it as it was when rates were cut to zero. The broader point is that the level of central bank rates and the associated level of investment returns are both driven by the macro-economic climate prevailing at the time and how investors respond to the changes in policy (change being more important than level).  The point is if we knew that the deposit rate was going to be X% in 5-years’ time, that in itself is insufficient information to establish any credible return expectations. It would be the factors that drove the ECB to that level of rates that would have been the dominating drivers of return. Buoyant economic growth would have very different return consequences across asset classes to a surge in inflation.

Negative rates don't mean negative returns 

So my point is that investors can still derive positive returns even when the prevailing interest rate environment is negative. In our outlook we do not expect any change in ECB policy for a long-time. That means the deposit rate likely remains negative over the medium-term. Will that necessarily drag returns on asset classes down to zero? Of course not. While it may be hard to get meaningful returns from the most interest rate sensitive asset classes, strategies that are exposed to changing credit conditions or equity earnings growth will still be navigating a range of return outcomes. The spread may be lower because the central bank has been able to foster a less volatile macro-economic backdrop, but this probably means better risk-adjusted returns. Since the ECB cut the deposit rate to -0.5% in September, the total return for the German government bond index has been -0.88%. For European high yield it has been +2.04% and for the Euro Stoxx index it has been 6.0%. Investors have a choice of keeping their wealth in cash and receiving no return or putting that cash in the market and allowing the long-term compounding of coupon and dividend income to work its magic. Additionally, if the wealth is invested in an actively managed strategy there is sufficient opportunity to add return through allocation to different risk factors over time. Asset prices have not stopped moving because interest rates are negative nor have returns gravitated to zero. Last year the total return from the Euro Stoxx index was 26%. Bond returns were strong as well, with the Euro broad market delivering 6.0%, the best returns for 5 years with interest rates significantly lower over that period.

But prices are higher because of central banks

There are concerns about central bank dominance in financial markets. Positive returns have made many asset classes expensive. Indeed, the presence of a large buyer of assets has significantly shifted the supply and demand dynamics, particularly in the bond market, to deliver higher prices and lower yields. Roughly the annual pace of ECB asset purchases is equivalent to around a fifth of the net amount of financial assets acquired by the household sector during 2019. It is a significant extra amount of demand for assets. Of course, it is price insensitive demand and focussed on higher quality assets where, perhaps, the room for additional price gains is limited, but the flow it creates adds to demand for more economically sensitive assets that do have room to appreciate in price. The real worry will come when the ECB stops buying even if interest rates remain negative. Then returns might come under significant pressure. Until then, the opportunity set for returns in bond and equity markets will remain sufficient enough for investors to have the opportunity to derive positive returns in their portfolios. Just look at this first month of the year. The broad euro bond market is up 1.75% when many of us thought that it would be difficult to get positive returns because of where yields where at the end of last year.

Another uncertainty

Again it is the fundamental background and its dynamics that count. Bond yields have fallen, credit spreads have widened, and equity markets have struggled in the second part of January because of fears surrounding the spread of the coronavirus in China and to other countries around the world. There will certainly be some economic impact even if the pace of contagion peaks quite soon. The Chinese New Year holiday was extended so many businesses could remain closed and this will show up in both Chinese activity indicators and, potentially, in the Q1 earnings of some global companies that have exposure to Chinese consumption or production. Hopefully the impact on human life can be limited but at the time of writing the number of people infected was still rising. The health and well-being of people should be utmost in our minds, but this is coming at a time when the economic data was beginning to confirm the more positive expectations that prevailed at the end of last year. The US corporate earnings season has been reasonably good so far as well even if overall EPS growth has remained unspectacular. Both the Federal Reserve and the Bank of England referenced the risk from the virus to economic activity, both announcing that interest rates would be left on hold for now. In the case of the UK, this was a bit of a surprise as a number of monetary policy committee members had indicated that a move lower in rates was on the cards. Apart from the human concerns coming from the virus, there is also a fear that any continued economic growth that was expected in 2020 was always going to be subject to unforeseen risks sufficient to raise the probability of a recession again. Certainly, the professional pessimists have been pointing to government bond yields approaching last summer’s lows and the US yield curve flattening again as signs of impending doom.

Au Revoir

It is the last day that the United Kingdom will be a member of the European Union, and the future remains uncertain. We do not know what kind of trade relationship will exist between the UK and Europe. Individuals are concerned about what the end of freedom of movement will mean for them, their ability to seek work or buy property in Europe or the UK (for European nationals). While there is more optimism around the UK economy since the election in December, my feeling is that this is more a reflection of the ending of uncertainty since the December election. So farewell, but not goodbye.

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