In the 1987 classic film Wall Street, Gordon Gekko (played by Michael Douglas) tells a young trader, Charlie Sheen, that, "greed is good". However, we all know that greed is the undoing of most, if not all investors.
Consider this: two years ago, investors piled into a 100-year bond issued by Argentina, with the lure of a compelling 7.9 per cent yield. Unfortunately for those who got suckered in, this week, with the Argentinian election surprise, those bonds have collapsed and are now trading at half their face value. The question is, what were people thinking?
When you look back in history, there hasn't been a 20-year period where Argentina has not defaulted. So what made investors think this time would be different?
They didn't care. Greed.
At the other end of the spectrum we have fear. Only 12 months ago, global interest rates were climbing again, and it looked like we might be reaching a point where there would be some long-term reward in the form of positive real returns for conservative investors.
Yet, thanks to an own goal by the Trump Administration, the trade war has pulled the handbrake on the global economy, with many forecasters putting the probability of a global recession in 2020 has high as one in three. As a result, in 2019 interest rates have collapsed, with investors rushing to the "safety" of bonds.
But how safe are bonds? Are you really being compensated for owning something that you are required to PAY the issuer? With more than US$16 trillion ($24.9t) in negative yielding bonds (this is climbing every day) and in many countries all yield maturities are negative, this global phenomenon is unprecedented.
This week, a Danish bank launched the world's first negative interest rate mortgage – handing out loans to homeowners where the charge is minus 0.5 per cent. This means the bank pays you to take out a mortgage. Has the world gone mad?
In New Zealand rates have collapsed too. Our own central bank, led by the sharp-witted and mercurial Adrian Orr, who successfully managed the NZ Super Fund through the GFC, is determined to ensure we are front footing a potential recession threat.
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In previous cycles, typically long-term interest rates must fall around 300 basis points to stimulate the economy and revive animal spirits. Since the trade war started in earnest, interest rates in the United States have fallen from a peak of 3.2 per cent to a recent low of 1.6 per cent (160 basis points) and in New Zealand from a level of 3.0 per cent to under 1.0 per cent (200 basis points) over the same time period.
The falls would imply that both countries could see interest rates close to zero - or even negative in the case of New Zealand - by the middle of 2020 if a recession were to come.
This could see one-year term deposit rates in New Zealand at 1.5 per cent and mortgages at 2.5 per cent. Other central banks, such as those in Europe, do not have the same level of firepower up their sleeves and have no choice but to resort to more unconventional stimulus or rely on Governments to boost spending.
In general, interest rates have been in a downward trend since the early 1980s, with each cycle having a lower peak. But this cycle was always going to present a problem if central banks could not lift interest rates to a reasonable level before the music stopped playing again. So what is driving the race to the bottom and what does this mean?
The negative rates reflect several factors, including declining inflationary expectations, too much debt in the system, central bankers wanting to keep extending the economic cycle and lower real rates as a result of weaker economic performance. The lower expected real rates of return suggest diminished potential growth. There are factors that would lift bond yields from their recent ranges, but a realistic assessment suggests they are unlikely to unfold anytime soon.
The pervasiveness and depth of negative bond yields, which is centred in Europe, is unprecedented. Yields elsewhere are at or close to historical lows and are being dragged down. Therefore, this leaves us with two binary outcomes at this point.
Firstly, the market is wrong. Growth bounces back and rates rebound as inflation finally returns, causing central banks to raise rates again – but ultimately this too must end at some point.
The other scenario is that rates keep falling or remain at zero/ negative for the foreseeable future. Growth is anaemic and distorted bubbles appear in all kinds of asset classes as investors are forced to own anything that might give them a semblance of return.
If banks in Europe are paying you to take out a mortgage, what kind of return can you expect from a conservative or balanced portfolio? Realistically, probably zero.
In this environment it means anything offering a yield will continue to get bid up. Including property, dividend paying stocks and stocks with strong growth (in a world with no growth).
Of course, if there is a recession, then asset prices will fall, but any such fall would be relatively short-lived because investors are greedy and need to make money somehow.
- Mike Taylor is CEO of Pie Funds.