Liabilities and the long-term effects of low rates

Long term view

We lived through history earlier this month. The Bank of England (BoE) raised interest rates for the first time in ten years. But interest rates will stay low for a lot longer yet and this should encourage those with a long-term view.

The move was symbolically important – a small, but significant, reminder that interest rates can move up as well as down. But of course it was no surprise. We were firmly steered towards a quarter-point rise by the Governor of the Bank. It simply reverses the cut made straight after the European Union referendum, and UK interest rates still remain exceptionally low by historic standards. In fact, the BoE is far from being alone in tightening monetary policy. At least 12 countries have done so this year, led by the US.

The reaction to the rate decision and, indeed, all of these moves has been fairly benign. The much anticipated big sell-off in government bonds has failed to materialise despite higher short-term interest rates and central banks indicating they will unwind their bloated balance sheets.

Rates versus returns

Even heightened political uncertainty – whether that be Brexit or North Korean missiles – has failed to shake investors’ nerves. This year has been a strong one for equity markets, which in many cases have hit record highs. The ability of financial markets to remain unperturbed in the face of so much change is causing some to worry. They see signs of largesse and bubbles forming.

Part of the concern for both investors and policymakers must be that, as the painful memories of the financial crash fade, so too has the heightened level of risk aversion that has dominated the last decade. Many central bankers – such as the Bank for International Settlements –have warned about the risks of too much debt building up driven by exceptionally easy monetary policy. History, however, seldom repeats, and the landscape that financial markets operate in now is very different to that of even a decade ago.

Of course, the level of some equity markets relative to their own history should give pause for thought. But their returns look pretty attractive when you compare them to interest rates. It is this differential between long-term interest rates and the returns available in financial markets to which we should pay most attention.

Increasing liabilities

One of the important, but largely unheralded, lessons of the financial crisis was not just to look at asset prices in isolation, but to pay particular attention to the liabilities they were matching or backing. Liabilities are an equally vital part of figuring out what will happen to investment returns.

The combination of regulation and massive falls in gilt yields has had the effect of inflating the liabilities of large institutional investors like pension funds and insurance companies.

A decade of ultra-low interest rates has kept the price of many of the so-called safe assets that pension and insurance companies hold high.

A decade of ultra-low interest rates has kept the price of many of the bonds that pension and insurance companies hold high. This has made it increasingly hard for these investors to achieve their required returns and forced them into perceived riskier assets. Moving into other assets has in turn reduced the returns available from them and the problem of meeting liabilities has only grown.

Indeed, if there is a bubble in financial markets it is arguably in liabilities. Whether the high level of liabilities concerns you or not depends on your view of what happens to the regulation and interest rates. If regulation remains as it is and interest rates stay low, then the conditions exist for liabilities to remain at this very elevated level for some time.

There is little or no sign of regulation changing soon. Similarly, interest rates may be rising very gently in some markets but they are very low by historical standards.

The inflation puzzle

Interest rates will also stay low as long as inflation does, and the prospects of inflation increasing significantly remain slim. It is not even clear why inflation is behaving as it is. My fellow economists are avidly debating why it is not performing as economic theory suggests it should.

Financial history demonstrates how inflation can remain phenomenally well anchored for long periods, while governments’ efforts to conjure it can take decades to have an effect. The US and UK in the 1930s-50s and Japan since 1990 are obvious examples.

Interest rates are indeed going to stay much lower than what we would have considered normal in the past. It is the structural impact of this across the investment landscape that is going to define returns in the years to come. Valuations might look scary in the short term but, over the long term, there is room to grow yet.


The article above was previously published on Aberdeen Asset Management’s ‘Thinking Aloud’ blog on 21st November 2017