Even lower for even longer: How low can they go?

Mark Carney

Interest rates held, for now….

Mark Carney surprised markets by not cutting interest rates. However, he has made it clear that he is poised to cut whenever the moment demands and while this threat hovers over markets, slightly bonkers asset pricing can persist. But while the high price of defensive assets may persist, it doesn’t necessarily mean that they will be a good investment.

For the bond market, it means that negative yields are likely to persist. At the start of July, for the first time ever, the 2-year UK bond yield turned negative. Germany has just become the first eurozone country to sell 10-year bonds with a negative yield in a government auction.  Investors can rail about the lunacy of negative bond yields, particularly at a time when inflation may be moving steadily higher thanks to recovering commodity prices, but there is little sign of the situation changing.

This has an impact in the stock market as well. The ‘bond proxies’, derided by many fund managers as too expensive and vulnerable to rate rises, now look like a reasonable option. A number of fund managers have pedalled back on their previous dismissal of ‘bond proxies’ and sought to distinguish between those companies that offer real long-term growth, and therefore inflation protection, and those that have stable, but static cashflows.

One asset allocator recently speculated that in a few years’ time, we may all look back on the pricing of defensive assets and wonder why we didn’t spot the storm to come. Certainly, every bubble looks obvious in hindsight. While it is possible to make a case for these assets staying at their current levels, it is difficult to make a case for them seeing significant appreciation. What would be the longer-term scenario that would see bond yields move even lower and support the high price of defensive equities? It may be too gloomy to contemplate.

It would see the UK in recession not for one or two years, as is most economists’ view, but in permanent structural decline, potentially in deflation. A Japan-like situation, if you will. It is not inconceivable, but it would suggest that all the strengths of the UK economy – a flexible labour force, its openness, its entrepreneurialism – would have come to nought. It would certainly fly in the face of economic theory.

There will be some pickings among defensive assets and the Brexit vote has given them a shot in the arm. However, in the long-term, the likelihood of generating inflation-beating growth from many of these assets seems slim.