For several years now we have been living in an environment characterised by falling short- and long-term interest rates combined with low inflation, low economic volatility, declining growth potential, accommodative monetary policies, etc. Asset management businesses have gradually adapted to this new world but in recent years a new stage has been reached: the financial crisis led to the further weakening of growth potential, unconventional monetary policies whose avowed purpose is to keep short and long rates low (or even negative) in order to counter deflationary pressures, restore over-leveraged players to solvency, and to regulations encouraging the buying and holding of sovereign bonds. It is now a question of adapting to a – potentially protracted– environment of low interest rates.
The purpose of this article is threefold:
First we assess the implications of this environment for the asset management business model. They are multiple:
- Re-examine the notion of a risk-free asset,
- Review portfolio construction, in particular the role and the level of government securities,
- Re-examine the notion of portfolio diversification,
- Re-examine the number of funds it is feasible and beneficial to hold,
- Revise – downward – the management fee structure,
- Fine-tune the quality of trade execution,
- Place the focus on advisory services, a differentiating factor.
The low interest rate environment has also led us to lower our projected returns for fixed-income assets and, as a result, for all portfolios that include bonds by design or as a precaution. We then go on to present in this article, different solutions that could deliver returns to the portfolios:
- Extend portfolio durations,
- Accept more credit risk (more credit, lower ratings, etc.),
- Add leverage,
- Take advantage of distortions in the yield curves,
- Search for assets that are undervalued because they are being shunned,
- Seek out assets with higher yields and lower volatility (ABS, infrastructure, private debt, etc.),
- Add a forex component to the portfolios,
- Capture liquidity premiums,
- Review the construction of the benchmarks we use (“Smart Beta” approaches),
- Use the big data / SMART data new environment in order to better understand information and trends,
- Better assess investment factors (“factor investing” strategies),
- Focus more on real assets,
- Allocate more to absolute return strategies.
Then we assess the prospects for exiting this environment of low interest rates by analysing the factors crucial for higher rates (growth potential, inflation, interest rate policies, unconventional monetary policies, fiscal policies, reducing the balance sheets of central banks, popping bubbles, etc.), as well as the risks of secular stagnation and the strategies to avoid them.
At last, we present some of the consequences of negative rates on different business models : banks, insurers, central banks, gouvernment issuers … these consequences may be sustainable. In sum, negative rates, to some extent, are reshaping part of the economic and financial environment. Do not underestimate their impacts.