A Long and Winding Road...
August 10, 2020
By Mike Moreland
VP - Investments
Last week the yield on ten year U.S. Treasury notes touched 0.5%, the lowest level on record. As the news went across the wire, it brought to mind the incredible journey interest rates have taken to reach this point – and the implications going forward.
Since the early 1980s, when Fed Chairman Paul Volcker took on the task of taming double-digit inflation (and succeeded!), interest rates have followed a generally downward path to where we stand today. See the chart below, courtesy of J.P. Morgan’s Guide to the Markets.
I started working in the investment field in (mumble…mumble…a while ago). It was a different era. Before the days of massive, ongoing Federal deficits and the accompanying expansion of Treasury debt outstanding, the bond trading community was a tight-knit fraternity (in the literal sense – there were few women in the business). Rumor had it that Salomon Brothers – a major bond broker – kept a comedy writer on staff to supply jokes to its sales desk.
All of the Treasury debt outstanding was listed in a few inches of column space in the Wall Street Journal. In fact, some of the more actively-traded issues were known by nicknames. The 10% U S. Treasury bond due in 2010 was the ‘Bo Derek’ (youngsters can Google the reference). My favorite was the 7% bond due in 2007; it was known, of course, as the James Bond.
But enough of the ramblings of a seasoned citizen...let’s look at where we are now.
The thirty-fold increase in the stock market since the early 1980s goes hand-in-hand with the decline of similar magnitude in interest rates over the same period. The oldest mechanism for equity valuation is the dividend discount model. In short form, it estimates future cash flows to be received from holding a security, discounts them by a given interest rate, and sums the series for a present (or fair) value. The higher the discount rate, the lower the estimated present value of a given stock. This principle also applies to a basket of stocks or a broad index.
What this tells us is that falling interest rates have been a wind at the back of equity investors for four decades. At the very best, interest rates will be a neutral influence on equity prices going forward. Rates cannot fall much further (we are not in the camp that expects negative interest rates as a matter of policy in the U.S).
The implication is that equity markets will now have to ‘pull their own weight’. This suggests that prices will advance more or less in line with GDP growth over the long run, plus a small inflation factor, with allowance for the inevitable cyclical swings that will take place.
This isn’t a bearish outlook – we firmly believe that the U.S. economic engine will continue to lead the world forward. We will participate, fully and enthusiastically, on behalf of our clients. What we do believe, however, is that the ‘easy money’ period is largely behind us. Consistent high single-digit or double-digit equity performance over a period of years will not return anytime soon.
The lesson for investors here is to be prepared. Adjust expectations, become more attuned to risk, and, most importantly, work to insure that your plans and portfolios are positioned for success. That’s what we’re here to help with. Talk to your Advisor today. Let’s see what the road ahead looks like for you.
PHOTO: Pictured is the famous Italian road to Stelvio Pass in the Alps.
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