"My investment returns stink and it’s your fault, central bankers!"
That seems to be the battle cry of long-suffering investors navigating a world of zero interest-rate policies and more recently -- gasp -- negative interest-rate policies of central banks around the world.
With all the bellyaching about negative interest rates, you would think that investors have nowhere to turn for positive expected returns, but nothing could be further from the truth. The reality is that the returns are out there to be harvested, but investors don’t want to invest where those returns are likely to be. That’s hardly the fault of central banks.
Whatever one may think of the economic merits of ZIRP and NIRP -- and there is no shortage of opinions -- everyone understands (or at least should understand) that central banks are not in the business of growing investors’ portfolios. (Monetary stimulus may sometimes have the knock-on effect of raising asset prices, but that is not its primary purpose, of course.) Central bankers are stewards of the macro-economy, and tasked with keeping a close watch on inflation and employment levels. They don't exist to make investors’ lives easier.
Some investors, however, come awfully close to sounding just like that. Larry Fink told Bloomberg in an interview this morning that "We’re harming savers worldwide with low and negative interest rates." Bill Gross recently expressed a similar sentiment, saying that negative yields guarantee investors will lose money.
It’s not surprising that investors are frazzled, especially those like Fink and Gross who, by necessity, may have to allocate some portion of their clients’ portfolios to bonds. Seven long years after the financial crisis, there is still lots of financial and market uncertainty to go around, and traditional safe havens still don’t pay. Just look at the largest and most stable economies in the world, as represented by the top seven countries by global equity market capitalization -- the U.S., Japan, U.K., Switzerland, France, Canada and Germany. The average yield on their three-month treasuries is a negative 0.12 percent. The best of the bunch is Canada, with a yield of 0.55 percent. Ouch.
The lowly state of interest rates has forced investors to take on more risk in search of return, and U.S. stocks have been an obvious and popular choice. The U.S. boasts by far the largest and most stable collection of companies in the world, representing 52 percent of global equity market cap. The U.S. has also been one of the few places with consistent growth in the post-financial crisis period. If you’re going to take risk, the U.S. is probably a sensible place to start.
The problem is that the popularity of U.S. stocks has squeezed their expected return. The normalized earnings yield for the S&P 500 was a generous 7.3 percent at the end of 2008 (calculated using ten-year trailing average earnings, excluding negatives), but now that earnings yield is just 4.4 percent.
That may sound like a satisfactory equity risk premium when the yield on three-month U.S. Treasury bills is 0.25 percent, but the U.S. equity risk premium relies on low interest rates to compensate for high stock valuations. In other words, in a normal interest rate environment, U.S. stocks would hardly offer any risk premium at all. This combination of high stock valuations and low interest rates is far from a sleep-easy bet.
There are excellent alternatives to the U.S., however. In fact, there are many, many places where investors can find lavish risk premiums. The next six largest countries behind the U.S. by equity market cap offer an average equity risk premium of 7.1 percent, and every one of those countries offers an equity risk premium that is well above that of the U.S. The lowest is a respectable 6 percent (Switzerland), and the highest is a meaty 8.6 percent (France).
Not only are equity risk premiums in those countries higher than in the U.S., but they are also qualitatively better because they are the product of low valuations just as much as low interest rates. In fact, central banks could hike rates by at least 2 percent in each of these countries (and in France by more than 4 percent!) before their equity risk premiums would approach that of the U.S.
I know what you’re thinking: These equity risk premiums reflect real risk. Japan will never grow again (6.6 percent equity risk premium). Europe is struggling with seismic demographic changes. Canada is in the throes of an energy meltdown (7 percent equity risk premium). Yes, there are those risks and more, but since when do investors get paid to dodge risk?
There are plenty of places investors can find respectable expected returns if they are willing to take risk. That is investing in its purest form -- parsing the markets for strong expected returns, with risk as the price of entry. Investors are also allowed to simply seek safety in negative-yielding, three-month treasuries. But they shouldn't complain about that choice, and they certainly shouldn't be carping about central bankers.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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Nir Kaissar in New York at email@example.com
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