Governments have two sets of policy tools to stimulate or slow down the economy. The first is fiscal: using taxes and public expenditure to directly affect what goes into people’s pockets and what they spend it on.
The other tool is monetary policy: central banks can raise or cut interest rates, influence the exchange rate or adjust the money supply in circulation, either through the reserve ratio or through quantitative easing. When I was in college, lecturers would always refer to Japan in the 1990s as the case study… but today they can refer to last month’s headlines.
Currently, interest rates are at historic lows, not just because of the actual rate itself, but because of how long it’s been there. If we take a quick trip around the world:
- Mario Draghi at the ECB has set rates at 0.05% and is ready to extend the existing €60-billion-a-month purchasing program until September, either by more or for longer.
- Mark Carney at the Bank of England has left rates at 0.5% and noted today, “Super Thursday”, that they could stay that way until 2017.
- Janet Yellen at the Fed hasn’t ruled out a rise from the 0.25% level this year and the markets are keenly awaiting the non-farm payroll results tomorrow, as this could be the trigger for lift-off on 16th December.
- At the People’s Bank of China, Zhou Xiaochuan has cut Chinese interest rates six times in the past twelve months to the current 4.35%.
- In the third biggest market in Asia, Roghuran Rajan at the Reserve Bank of India has cut the interest rate four times this year to 6.75% as it would be difficult to do so later in the year if America raises their rate and money rushes out of the emerging markets.
- Glenn Stevens at the Reserve Bank of Australia is watching how the rest of the world tentatively makes its way into 2016 while his domestic economy shifts away from mining. On Tuesday, they released a statement articulating that the rate is to be left at 2% with a view to increasing it at some time in the future. If inflation required it, they could deviate to easing it also.
- Brazil is in a difficult place of stagflation: rising inflation with a simultaneous recession. In particular, it is going through a severe rise in prices because of a deep decline in the value of its currency. In the Central Bank of Brazil, Alexandre Tombini has set the rate at 14.25% with foreign exchange rates high on his problem list.
- Last Friday, the Central Bank of Russia announced they would keep the key rate at 11% in light of “persistent substantial inflation risks” to the downside, as Elvira Nabiullina is dealing with declining inflation (aka disinflation) into 2017.
- At the Bank of Japan, Haruhiko Kuroda has set the interest rate at just 0.1%. Last Friday, it reduced its growth and inflation targets and the markets are expecting further quantitative easing in the months ahead.
In this context of terribly low base rates, where can investors look for sources of return?
Different asset classes require different investing
strategies in a low interest rate environment
Asset class: Cash
Now is not the best time to be keeping your money in cash in a savings account.
On the 10th September 2014, the ECB announced that they would be charging 0.2% if banks were to deposit money with them. This 0.2% charge was a doubling of the rate they had been charging in June. The ECB was sending out the very clear message that they didn’t want money resting in their account: instead, they wanted to encourage banks to lend it out into the real economy where it could spur growth.
The reference rate for interbank lending, EURIBOR, which indicates the average cost one European bank charges to lend to another, is negative up until a six month maturity (and even at that, a bank can only make 0.003% over that period).
As a result, banks are offering exceptionally low interest rates to savers. For example, BOV is offering 0.05% on “any balance” (Bank of Valletta – Malta). While these rates are barely above zero, they are still above inflation: we are still experiencing deflation in Europe at a rate of 0.1%, currently driven by the fall in the oil price among other things.
If you’re a saver in Europe today, you aren’t going to make much money in nominal terms and your real purchasing power will improve only marginally.
Are there solutions for cash holders?
However, if you wish to try a different approach with cash, there is an alternative. You can take advantage of different monetary policy in the US and in Europe: Janet Yellen is continuing to warn of rising rates while Mario Draghi is currently considering which tactical approach to adopt when it comes to increasing quantitative easing. As a result, there is a wedge being driven between the euro and dollar. As soon as there is announcement about a rise in rates in America, we can expect a rush of money to flow into US banks to gain a higher yield. This would drive the dollar up to a higher level, after it has risen steadily over the past five years, and at an even more acute rate since 2014.
As a result one could consider a cash strategy of simply holding dollars in a low yielding savings account in the US, on the expectation that both the interest rate and the exchange rate should rise. However, this carries some risk that the foreign exchange rate would depreciate unexpectedly, or that everything has been already priced into the market; in that case your risk wouldn’t be rewarded by further FX movements. As a result, if you’re a saver you need to be clear that this isn’t just a cash investment plan, but a cash investment plan with exposure to uncertain FX movements which could result in capital loss.
Asset class: Bond Market
The sovereign, government bond market has picked up pace amid growing fears of default, particularly since 2008. As a result, a complaint of fund managers globally is that they have “run out of yield”. For example, at the time of writing, the 10 Year US Treasury, Japanese JGB and German Bund are yielding 2.23%, 0.31% and 0.6%. This means if you lend money to these governments, you’re locking in these meagre returns for ten whole years.
Therefore, if you want to put money into the debt market, you’re going to have to increase your risk profile, either by choosing a different market, or by venturing into the corporate bond universe. In the case of the former, you can consider emerging market debt, EMD. For example, the Russian (rouble denominated) 10 year bond yield is 9.69%. The 10 year Brazil (highly depreciated real denominated) 10 year yield is 5.56%. The 10 year Indian (rupee denominated) 10 year yield is 7.65%. On average, local currency emerging market debt yields about 6.5%, an attractive offering to any investor seeking bond returns.
However, this higher return comes in the form of two important higher risks. One is that the local currency depreciates against your own home currency: this is to be expected if you’re a dollar investor at the moment, given US monetary policy expectation. The second is that emerging market economies themselves have slowing growth, which directly relates to their making good on payments.
The other opportunity you have is to go into high yield (aka non-investment grade or junk) bonds which offer a higher yield, but have a much higher chance of default. I’ve done this personally through an Exchange Traded Fund vehicle in the past. Rather than taking a chance on one junk bond, I wanted to diversify across several, which is why I chose an ETF. In addition, rather than have to pick out the security myself, I was happy to leave this to the portfolio manager. Then I only needed to research what currency, what quality, what yield, what maturity and what geography I wanted. They were enough decisions to make at the time! I went to the High Yield Corporate Bond Section of iShares to find seven different choices. I have since sold the position, but I bought some shares of iShares Euro High Yield Corporate Bond UCITS ETF because it was denominated in euro. This eliminated currency exposure, had a high dividend yield (and this is 4.48% today), and offered diversified exposure across global geography, sector and maturity with a Total Expense Ratio of 0.5%.
Asset class: Equities
Developed market equities have been rising since 2009 and are bolstered by continuous quantitative easing. However, many investors are concerned that the market is overvalued and they don’t want to walk into a downward slump.
The total return of stock market returns comprises both dividends and capital appreciation. The first is relatively easy to find; let’s say that you take the list of stocks that make up the S&P 500 or the FTSE 100, so that you can examine large companies with a lot of volume. Rank this list by dividend yield and then ensure that the dividend is well covered by earnings, that is, the earnings yield is greater than the dividend yield. You can do this manually or by using a stock selection software program like the one offered by VectorVest.
Seeking greater capital appreciation is a more difficult task as the amount the stock is going to achieve isn’t spelled out for you, as is the case with dividend yield. In this scenario, it’s important to find stocks that offer good value. I have a number of stocks in my portfolio that fit these characteristics (e.g. Colgate) and I turn to Rory Gillen’s newsletter for analysis GillenMarkets. He noted on the 12th September: “On the basis of 2016 forecast earnings, the shares are currently trading on a price-to-earnings ratio of 19.8 times, circa 6% below the long-term average price-to-earnings ratio investors have afforded the group since 1989. Thus, the shares seem fairly valued relative to history. The prospective 2015 dividend yield is 2.4%; with growth of even 6-7% per annum, annual returns of circa 8-9% are very possible on a medium-term view.” I apply my own options analysis to craft the position into what suits me optimally (see below).
Asset class: Property
Property is going to be a natural beneficiary of low interest rates: the cost of borrowing is low for property developers to create the product, and also for people borrowing mortgages to buy. This does create price inflation, pricing many people out of the market and leaving them no choice but to rent.
In essence, low interest rates creates upward pressure on both the capital (i.e. price of housing stock) and the income element of this asset class (i.e. rental yield). The problem is of course, that property often requires at least a six figure investment into just one unit and is highly illiquid if you want to sell quickly. The market has come up with a happy middle ground in the form of a REIT, Real Estate Investment Trust, a closed end fund which gives an investor listed exposure to this asset class. For years now, I have held a position in the Hansteen Investment Trust, a UK and pan-European property fund. It continues to deliver a solid return in both of the above. A variety of REITs in Ireland have proven both popular and profitable, including the Green REIT and Hibernia REIT.
Asset class: Hedge Funds
The hedge fund universe can do what it wants, whatever way it wants so long as it delivers a positive return. Its mandate is not necessarily to outperform the stock market indices. Hedge funds can buy whatever assets they like, with leverage if they choose, using both long and short exposure to do so. As a result, the interest rate variable they’re faced with is only one factor of their environment, as opposed to a defining characteristic, as it is for other asset classes that we discussed earlier.
In essence, a hedge fund doesn’t need to reflect the fluctuations of the economy or the stock market at all: this might be where opportunities can be found, opportunities that may well hold the elusive yield so many other asset-class-specific mandates can’t find. However, the fees associated with management of these structures can be higher. Let’s take the example of Ruffer Investment Company. It states that its principal objective is to deliver “a positive total annual return, after all expenses, of at least twice the Bank of England Bank Rate by investing predominantly in internationally listed or quoted equities or equity related securities (including convertibles) or bonds which are issued by corporate issuers, supranationals or government organisations”. The total expense ratio is a steep 1.18%, much higher than the vast majority of ETFs today, reflecting a premium for asset management costs. It contains a variety of index-linked domestic and international bonds, gold-related securities, options, cash, a plethora of equities from all over the world as well as illiquid strategies.
As regards performance, this hedge fund was launched in 2004 and apart from the period between 2006 and 2008, it has absolutely delivered upon its objective to double the BOE rate. However, when you take a look at the graph, what is striking is that it has a slow, steady upward trend, apart from a couple of bumps. This is in stark contrast to the roller coaster the FTSE 100 would have taken you on over the period. The downward periods were much less extreme, with a maximum drawdown of 7.36%: this would have offered a level of reassurance and comfort that were out of this world during the storm of the financial crash years. All that said, it actually outperformed the FTSE All-Share Total Return index by 8.6% over a ten year period, and with a lot less drama.
Asset class: Private Equity
In my training courses, I always explain “Private Equity” as what people see on Dragons Den, because that’s exactly what it is. People with money (angel investors, venture capitalists, private equity funds, etc.) seek out direct holdings in businesses. They choose to invest in businesses which they believe will offer a return on investment well over the rate they could achieve on the listed markets.
Many, many businesses will run out of steam (or money) after burning through the cash, or else they will be mired in mediocre returns and the investors will find it difficult to liquidate their position, because there won’t be a natural buyer for the stake. Other investments could turn out to be the next Silicon Valley celebrity IPO like FaceBook, Google, or even the eagerly-awaited announcement of a newbie like Airbnb or Uber. This is a place where you can do very well, or very badly, or both.
This asset class requires more than investment knowledge and technical skill: investors also need a lot of business savvy and commercial experience. It’s highly, highly illiquid and exceptionally dependent on key characters. The interest rate environment gives easier access to low cost borrowing, but many of these companies don’t have revenue or profit to service these loans, so debt financing isn’t a natural fit: the interest rate environment has less impact on the recipients of the funds. Of course, many of the investors use their own lines of credit: low interest rates are simply helpful to them.
Because of the specialised nature of this asset class, I’ve taken the fund route here again instead of choosing one business to invest in, Dragon’s Den style. There is a selection of relatively liquid investment vehicles to enable exposure to private equity. I have turned again to GillenMarkets analysis for my choice of the sterling-based Graphite Investment Trust: a company which specialises in management buyouts of mature, profitable companies in the UK and Europe. Rory Gillen notes that “Graphite Enterprise has developed an excellent long-term track record, generating growth in its net asset value (NAV) of 11.8% compound per annum since 1995.” It has delivered a 10 year growth rate of 125.6% and again outperforms the equity indices with a steady dividend throughout.
Asset class: Commodities
Traditionally, commodities have been viewed as the ultimate hedge against. Inflation is the measure of the increase in the price of goods, and commodities are those very goods: oil, sugar, wheat, coffee, etc. Given that we don’t have inflation at the moment, nor inflationary pressures, you might question whether, in the current environment, commodities should form part of a portfolio at all. Then there are the developments in oil price. That said, I read a rounded, well-researched piece by Michael Brewster from Credit Suisse recently about the future of oil reserves and supply that paints an interesting long term picture where this commodity is going.
However, I do hold some commodity companies (with good business models) in my portfolio for diversification. These have been suffering a lot in recent months, given that their product has been falling in price. In fact, they have been the greatest source of red in my results so far this year. Thus far, I’m willing to hold on to them as long as they’re productive and seeking to deliver better results, but I have been using options to generate an income from them as a synthetic approach to soften the blow. I would have been better off if I hadn’t bought them at all until now, but that’s hindsight for you; and for now, their investment case still earns them a place.
How to use options derivatives to craft investing
strategies for a low interest rate environment
I use options derivatives in my portfolio to craft my strategic positions. I’ve been interested in them since college, when I researched them in detail for my thesis.
I referred earlier to my holding in Colgate. Two weeks ago, “Super Mario” announced that the ECB was considering extending the Eurozone quantitative easing programme: the markets lifted immediately. I saw my Colgate shares rise by over 2% and waited until the trading day was over, to see if the profit takers would erase the gains. It held firm and so I decided to sell a covered call.
In essence, I agreed to sell my Colgate shares in November for higher than the current market price (aka out-of-the-money) in exchange for a small fee. In other words, if Colgate rose even further by the end of November, I would sell off my holding to somebody who was extremely bullish: such an investor would be planning on Colgate to rise further and would be happy to buy the right to lock in a price for the share that will be lower than market price on the day they acquire this share.
These are the numbers:
- Thursday 22nd October: CL Share price $68.64
- I struck the call for November at $70
(If requested, I will sell the shares at this price)
- I received a premium per share for this of $0.77
Now, some might question why I would give away upside for such a paltry amount of money, but let me contextualise: the quarterly untaxed dividend for Colgate is $0.38 and I’m able to achieve double in one month.
Further than that, I want to limit the portfolio risk and I can do so very cheaply using options too. I can use some of the income I generated from the covered call to pay for temporary downside protection in the form of “protective puts”. For example, for $0.26 per share I can buy the right, but not the obligation, to sell my shares for $47.50 (the strike price), and this insurance stretches out to May 2016. I can combine the two together: I can use a covered call (I sell the right to buy from me at a certain price) to pay for a protective put (I buy the right to sell at a certain price). This is called a collar: I have basically locked in a range where my outcomes sit. If I match the amount I receive from the covered call to the amount I pay for the protective put, this is called a “zero cost collar” because I establish a cap and floor without using any of my existing capital to do so.
One last point on this, I can also sell put options to decrease my cost when taking on a position. For example, every time that I give an investing seminar in Brussels, I’m constantly asked to analyse Ageas, one of the best performing stocks in the BEL 20 this year. Currently, the price is €39.18 and if I agreed to buy this at €38 in January (approximately 3% below current market value), I could generate €0.69 per share (which is 1.7% in 3 months based on today’s price). This may not sound like a lot of money, but this example takes a very conservative approach. I could make more if I agree to buy it closer to today’s price and even more if I am willing to buy it higher than the listed price. The risk here is that Ageas could rise by much more than what I make using this route, which of course it can. This has happened to me in the past and I have lost out, but overall, I prefer this approach to taking on a position, as I can make a clear amount of money before I start. In fact I very rarely buy a stock any more without selling a put first if there is a liquid options market.
A low interest rate environment makes investing returns elusive and will prompt investors to look for nooks and crannies where low rates are irrelevant, or to adopt riskier and/or more creative investing strategies. Having good, up-to-date knowledge of different asset classes and other strategies will help you spot opportunities.
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