Conventional wisdom in the investing world expects interest rates to rise over the next two to three years. Several pundits cite history and the slowly improving domestic economy as their evidence. However, that position ignores some very important reasons to believe interest rates could remain low for much longer than anticipated.
Low Rates Are a Global Phenomenon
Over the long term, interest rates are a function of economic growth and inflation. Historically, gross domestic product (GDP) and interest rates tend to track each other very closely. Since 2008, both developed and emerging economies have seen a slowdown relative to their trend growth rates prior to the financial crisis. With the exception of a few places like India or Brazil, global inflation is also quite low. In fact, in some countries, such as Japan and the United States, inflation is actually running below central bank expectations.
Economic growth trends and central bank policies in Europe and Japan both play key roles in the direction of interest rates. In aggregate, the Eurozone is the largest economy in the world, making it relevant to the direction of interest rates. It appears European nations have avoided a break up, but there are still significant issues that need to be addressed. Most importantly, flows continue to move from the weaker countries to the stronger countries. Given this backdrop, it is quite likely that central bank policy for the region will continue to be dictated by its weakest members.
The Japanese have outlined a three-pronged approach—dubbed “the three arrows”—to help address their current economic position. The first of the policies to be implemented was the large-scale asset purchases by the Bank of Japan (BOJ), which has been extremely successful, increasing the BOJ’s balance sheet substantially. The challenge for the BOJ will be to keep inflation from spiraling out of control while keeping the yen from depreciating too quickly.
China is currently grappling with its own structural issues. Most importantly, investment as a percentage of GDP is currently tracking at about 49%.1 This is much too high. For China to have a stable economy over the long term, it will be necessary for this to shrink and consumption as a percentage of GDP to grow. Policymakers in China understand this and are implementing policy actions to slow the economy and allow for consumption to grow over time. Unfortunately, for the rest of the world this means that global growth is likely to slow with China, and that has implications for a slowdown across the emerging world and in the commodity super cycle.
Sources: U.S. Bureau of Economic Analysis, Federal Reserve Bank, ISI Group, as of 6/30/13
Nominal GDP is smoothed over 10 years. Forecasts may not be achieved. Past performance does not guarantee future results.
The Outlook for the U.S.
Our base case scenario right now is that growth in the U.S. will continue to be in the 1.5% – 2% range. This level of growth is below long-term trends, and in the near term we don’t see a major catalyst to break us out of this rut. Additionally, many people were counting on housing to be the driving force behind a strong recovery in the United States. Unfortunately, housing recoveries tend to have a small direct impact on GDP. With mortgage rates in the U.S. rising rather dramatically since the Fed began talk of a QE taper, we’ve already seen a slowdown in refinancing activity, and this will also increase the cost of housing to many potential buyers. The Fed has also stated that it will keep monetary policy accommodative until we reach a 6.5% unemployment level or breach a 2.5% level for inflation.
We don’t expect interest rates to rise anywhere until global GDP does. But we do believe this low interest rate environment has significant investment repercussions and makes some asset classes, including senior loans and master limited partnerships, particularly attractive.
Source of chart data: BLS, Barclays Live, Bloomberg, and Morgan Markets. The Barclays U.S. Aggregate Treasury Index represents public obligations of the U.S. Treasury with a remaining maturity of one year or more. The Barclays U.S. Aggregate Bond Index is an investment-grade domestic bond index. The Credit Suisse Leveraged Loan Index is an unmanaged index that tracks the performance of senior floating rate bank loans. The Barclays High Yield Bond Index represents the U.S. high yield debt market. The Barclays Aggregate Bond Index is an investment-grade domestic bond index. The indices shown are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results.
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This story previously appeared on OppenheimerFunds.com.
1 Source: The World Bank 2/28/14. Fixed income investing entails credit risks and interest rate risks. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall. Investments in below-investment-grade (“high yield” or “junk”) bonds are more at risk of default and are subject to liquidity risk. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and political and economic uncertainties. Emerging and developing market investments may be especially volatile. Diversification does not guarantee profit or protect against loss. Senior loans are typically lower rated and may be illiquid investments (which may not have a ready market). Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. Each Fund’s investments are concentrated in the energy infrastructure industry with an emphasis on securities issued by MLPs, which may increase volatility. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations, which may result in erratic price movement or difficulty in buying or selling. Additional management fees and other expenses are associated with investing in MLP funds. The Oppenheimer SteelPath MLP Funds are subject to certain MLP tax risks. An investment in Oppenheimer SteelPath MLP Fund does not offer the same tax benefits as a direct investment in an MLP. The Funds are organized as subchapter “C” Corporations and are subject to U.S. federal income tax on taxable income at the corporate tax rate (currently as high as 35%) as well as state and local income taxes. The potential tax benefit of investing in MLPs depends on them being treated as partnerships for federal income tax purposes. If the MLP is deemed to be a corporation, its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution, which could result in a reduction of the fund’s value. MLPs funds accrue deferred income taxes for future tax liabilities associated with a portion of MLP distributions considered to be a tax-deferred return of capital and for any net operating gains as well as capital appreciation of its investments. This deferred tax liability is reflected in the daily NAV and as a result a MLP fund’s after-tax performance could differ significantly from the underlying assets even if the pre-tax performance is closely tracked. These views represent the opinions of OppenheimerFunds and are not intended as investment advice or to predict or depict performance of any investment. These views are as of the open of business on March 21, 2014 and are subject to change based on subsequent developments. Carefully consider fund investment objectives, risks, charges and expenses. Visit oppenheimerfunds.com, call your advisor or 1.800.225.5677 (CALL-OPP) for a prospectus with this and other fund information. Read it carefully before investing. Oppenheimer funds are distributed by OppenheimerFunds Distributor, Inc. OppenheimerFunds Distributor, Inc. is not affiliated with Forbes.
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Source: Forbes Business