Personal Finance

Global interest rates likely to stay low: Arvind Rajan, MD of PGIM

Lokeshwarri SK Vivek Ananth | Updated on December 23, 2019 Published on December 22, 2019

ARVIND RAJAN, MD, PGIM Fixed Income

A glut of savings provides the technical backdrop for this outlook

 

As 2020 begins, the US-China trade war is showing signs of abating slightly. But low interest rates and bubbles being formed in many pockets are posing challenges to investors. Arvind Rajan, Managing Director, PGIM Fixed Income, shares his views on managing the low interest rate regime, the consequences of central bank polices and the link between bond and equity prices, in an exclusive interview with BusinessLine. Excerpts:

What is your view on the global interest rate trajectory? How long will they stay at the current low levels?

Global interest rates are likely to remain stuck near their lows for the foreseeable future, and to trade in a range around those lows depending on cyclical macro and technical factors. The global glut of savings provides the technical backdrop for this outlook. The anaemic growth and low inflation invite easy policy and QE from G-10 central banks.

A number of powerful secular factors that have underpinned this phenomenon look set to remain in place in the coming years. These factors include high debt levels which depress growth, an ageing demograpy in most countries along with a shrinking workforce, the disinflationary forces of globalisation (now under siege, but still powerful) and technology, economic inequality and other factors.

In the light of low interest rates in most geographies, how do investors and savers tackle their investment plans, to save for the future?

The unfortunate reality for global bond investors is that they are the primary victims of the low yield epidemic. The reach for yield we are seeing across the world is largely a consequence of the global savings glut seeking better returns. I don’t have a silver bullet, but I would suggest some logical principles that can help to manage through this low yield environment. The first is to lower return expectations for fixed income and cash – with projections for the coming years based more on the current environment rather than on higher yield regimes of the past– requiring increased savings and lower future withdrawals or disbursements.

The second is to fully exploit the global range of available cash and debt markets and reduce home bias. The third would be to favour higher yielding and steeper interest rate curves. The fourth would be to selectively look for credit sectors and issuers that can offer value on a risk adjusted basis. In summary, judicious active selection and optimisation and reduced expectations may be the only solution for investors in a protracted period of low global yields.

The markets seem to be in an exuberant mood after a deal has been signed between the US andChina. Where do you see the trade war going after signing of the phase one deal recently?

I think that the markets are correctly optimistic about an end to this current phase of negotiations. And I think they see this as a reprieve because it has been fairly a large source of volatility for risk assets. So, any kind of deal even if it is incomplete or even if it is only the first phase of a protracted process, would be viewed as a positive by markets.

It’s the first of a multi-year series of risks for global assets arising from the substantially changed nature of the relationship between the US and China. From the US side, it’s not only Trump that’s leading the trade war. At this point, there’s been a complete change among both Democrats and Republicans in terms of how they view China. And the president actually has bipartisan support to pursue a more aggressive agenda, particularly with respect to intellectual property.

And with respect to foreign policy, if you expand the idea of a trade related dispute to one that includes strategic, military and geopolitical considerations, then China and the US have not really resolved their differences. That is why I think that, even though we may get a deal now, we will undoubtedly have disagreements in the future around some combination of these issues.

What could be these disagreements in the future?

One that may be the most impactful to markets is around intellectual property because it prevents cross fertilisation of economies in a significant way when the conception of who owns data is so different.

In the US, largely speaking, the data is owned by corporations. In Europe with GDPR, the data ownership has shifted to individuals and their data privacy is heavily protected. And in China, data is centrally-owned. These paradigms are in conflict with each other, and, therefore, much harder to resolve than simply sitting across the table and striking a deal. Others include the South China Sea, North Korea, human rights-- the potential list goes on.

Quantitative easing (QE) by central banks and lower interest rates compared to their historical levels have led to asset price inflation. But growth is a concern, across the globe. How do you think all of this will unravel, going forward?

I don’t know the answer, to be frank. So, let me let me address two points. First of all, the issue of stock valuations cannot really be separated from the issue of bond valuations, because earnings yields are a metric of the value of the stock market, and should be compared to what you earn from investing the same amount in bonds.

When bond yields drop, that has a competitive effect on stock yields and they tend to get pushed down, and prices correspondingly get pushed up. Everything else being equal, I think that the stock multiple, which is the inverse of the yield, should be higher if bond yields around the world are permanently low, creating an intimate connection between stock and bond valuations.

Traditional measures of stock valuation including the famous Shiller CAPE which is basically the ratio of the stock price to the average earnings for the last 10 years-- tend to be mean reverting over long horizons. And right now, CAPE tells you that stocks are expensive, and that they should, therefore, depreciate somewhat over the next 10 years, leading to lower return of 3-4 per cent for the US stocks. However, CAPE doesn’t take into account the idea that bond yields are low. It ignores bond yields completely. It lives only in a stock universe. If you take bond yields into account, maybe that’s not really true.

Does that mean that stock valuations are not in bubble territory?

There is no question that to some extent lower bond yields have directly contributed to higher equity valuations. Due to lower interest rates, companies borrow money and then they do stock buybacks with that money. That’s increasing stock valuations. I don’t want to venture a guess as to whether risk assets are priced too high, and that things have to crash.

We have plenty of doomsayers out there that love to do that. But we need to view this in the context of a world where savings and assets are artificially separated from places where the demand is potentially coming from. Think about emerging economies, they have $65 trillion of infrastructure needs over the next 25 years, according to the World Bank. Where is that money going to come from? There’s a lot of savings, but it’s not getting directly deployed towards those needs because of various factors, such as institutional barriers, governance issues and thin markets. Instead, it goes after large, liquid developed country assets.

It’s probable that we are at the point of the cycle where there are many mini bubbles. And some of those bubbles may burst at times. The bursting of those bubbles is usually contingent on other things also going wrong. There are some bubbles in some pockets of the private equity and debt market, where there may be excessive valuations. Some pockets of structured credit, which are now coming back after the crisis, some pockets of corporate debt, and some emerging countries.

Idiosyncratically, we have seen several countries blow up over the last two years. But I don’t yet see the catalyst for a larger conflagration that brings down global assets, though that is a risk. Instead, what I do see is lower returns because whatever your cash flows might have been, if you keep that constant, clearly you are going to get less returns if you pay a higher price for those cash flows. I think that that is the way that it ends with a whimper rather than a bang.

Are you seeing any regulators who are aware of what you’re saying that there are many bubbles everywhere and want to arrest this asset price bubble?

Financial stability is built into the mandates of some central banks, but not all central banks. So, it’s their job to fret about this. But you can’t find instances where the central bank has actively curbed the market by for example, raising interest rates because they think equity valuations are too high. And that’s because no one knows when the equity market is overvalued. The value of the equity market is dependent on future cash flows that no one can predict. So, who’s to say that a 19.2 multiple of trailing earnings for S&P 500 is too high but an 18.5 multiple is okay? And where do you stop? How do you wield that particular stick?

The US Federal Reserve in their commentary have been saying that they are worried about asset price inflation

I think that they take it into consideration. It’s something that they study carefully. They put that in along with everything else, mix it up and out comes the policy. Supposing all your other indicators like inflation and economic growth are well under control and at target, and suppose we are at full employment in the US, but there’s no sign of overheating in the job market. The Fed will hold interest rates like what they did in the recent monetary policy meet. Suppose stocks go up another 10 or 20%, will the Fed raise rates? I don’t think so. I think it’s really hard to use asset price inflation as the primary reason to act.

A view that is emerging slowly in India is that maybe the inflation targeting mechanism of the central bank is not fit for India, and that it has probably depressed growth. Is there any substance to that argument?

India has not solved its inflation problem fully. I mean, onion prices have quadrupled this year, for example. And I think it’s appropriate for the central bank to make inflation targeting the first, if not the only, element of its policy making objectives. The RBI has largely followed an appropriate policy path, even if one may quibble with a particular move. And I think it’s been a successful path in terms of delivering, until relatively recently, strong growth along with moderate inflation. The fact that growth has come down so much this year is probably not because policy was too tight.

In India, we have many global funds that invest in global equities and that provides very good geographic diversification. Why do you think AMCs don’t have global funds that take an exposure to global bonds of other emerging markets?

I think that most Indian investors don’t buy even US treasuries let alone all the other global bonds. I think that US Treasuries and other global bonds are still a very good diversifier. And in particular, they are a buffer against recessionary shocks to the global economy, which will tend to hurt risky assets. If there is 10-15 per cent currency fluctuation every year, it’s legitimate to ask why one should endure a 15 per cent risk to earn 2 per cent? Well, you can hedge your currency back into rupees, reducing the volatility of global bonds and increasing the hedged yield. Now, it requires a certain degree of sophistication to do that, making it unviable for retail investors. So, I would suggest global bonds mostly for institutional investors who have the ability to hedge that currency risk.

Published on December 22, 2019
This article is closed for comments.
Please Email the Editor