Central banks first introduced low interest rates following the 2008 global financial crisis. They have remained in place due to stubbornly weak economic growth and low inflation.
As base rates have moved closer to zero, the likelihood of widespread negative interest rates has increased. Already the Eurozone, Switzerland and Japan have entered negative territory. The US Federal Reserve and the Bank of England are showing signs of a similar move.
In 2009, Sweden’s central bank, reduced its overnight deposit rate to -0.25%, further cutting it to -1.00% in 2014-15. The European Central Bank took a more tentative step in reducing its rate of return to -0.1% in 2014. Japan also cut to -0.1% in 2016. Switzerland dropped its rate further to -0.75 in 2015. To date, Sweden is the only member of the club to revert to a positive interest rate, which it did in 2019.
Goal vs Reality
Low interest rates make borrowing easier. Thus, according to conventional wisdom, it encourages economic expansion. Companies make massive investments contributing to rising employment levels and improved GDP growth. It encourages consumers to spend or invest more widely.
However, the benefits of interest rate reductions have proved harder to define. There is a growing body of evidence suggesting that low interest rates fail to create growth. A recent research report indicated that low interest rates could be counter-productive. Damage to the economy includes market concentration, unproductive investments and increased trade deficits. Consequences include higher levels of debt and economic stagnation.
The recent tightening of the regulation has made banks more reluctant to extend credit. Thus, leading to more cautious loan arrangements. Consequently, individuals and companies with the greatest need can find it much harder to borrow. The contraction of borrowing puts pressure on the bank’s profitability.
Another important fact of negative interest rates is the impact on the cross-section of society. On one side, we have wealthy individuals who already own extensive financial holdings. Those class members already enjoy disproportionate amounts of capital. By contrast, the middle class and retirees suffer because of their dependence on savings which offer low returns.
Low or negative interest rates also feed asset bubbles. Consumers turn to the stock market in their search for investment opportunities with a viable return rate. Thus, driving today’s rich assets valuations.
The impact of economic shocks
The experiment with low or negative interest rates has failed. As opposed to the expectations, it did not bring about steady economic growth across international markets.
This situation has been made worse by Covid-19, which affected both the supply and demand sides of the economy. The pandemic disrupted global supply chains and upset consumer confidence. It prompted governments around the world to close their borders, severely restricting movement. Today, consumers and businesses are in survival mode waiting for the crisis to pass. Due to market uncertainty, it is unlikely that lower interest rates will encourage more borrowing.
Furthermore, interest rates in most developed countries are already close to zero. There is very little space for central banks to manoeuvre in case of further economic shocks.
The world is clearly in need of more active measures to bolster the struggling economy.
The rise of Alternative Investment options in a low interest world
Against the backdrop of low or negative interest rates, investors must carefully consider the range of opportunities open to them in 2021.
Today, major assets are highly valued and offer less assurance of positive returns in the coming months. Meanwhile, fixed income and credit markets are uncertain due to low interest rates. It is time to re-balance your portfolio and spread the risk among less-correlated assets.
Alternative investments offer a more conservative approach by insulating against economic shocks and any widespread loss of market confidence. However, lower market transparency, efficiency and liquidity mean that risk management and due diligence are essential watchwords.
One important attraction is the broader level of interest in alternatives due to the current low interest environment, which can drive higher returns. Furthermore, these assets provide a counter-cyclical portfolio balance.
Positive factors to drive investor optimism in 2021
Despite the difficulties of identifying substantial opportunities in highly valued global markets, there are some signs for investor optimism in 2021.
On the political scene, the election of Joe Biden should bring the USA back into the Paris Accord and boost green industries. With numerous other countries already making commitments to become carbon-neutral, the trend towards ESG (Environmental, Social and Corporate Governance) investing looks strong. The winners in renewable energy and transport could well enjoy exponential growth in 2021.
In terms of technology, the pandemic brought disruptive innovation to the fore. The current trends in digital payments, digital health, machine learning and digital content distribution and advertising are likely to accelerate further.
Having made the earliest recovery from Covid-19, China is a standout candidate for economic growth in the coming year. The mainland economy has been set on a renewed path towards domestic growth, summarised in Xi Jinping’s “dual circulation” strategy, which sets an agenda for reduced dependence on overseas technologies. At the same time, the mainland will focus on bringing growth to lower-tier cities where there are some 500-600 million people with the potential to become middle class between now and 2035.
A general sense backs these trends that business optimism is likely to rise further along with hopes for a successful vaccine for the current pandemic. These factors may lead to a steepening yield curve indicating more robust economic activity, increasing inflation and higher interest rates.
The current situation opens the door to some exciting investment opportunities:
The equities market can best be targeted selectively. Consider individual stocks that address the buoyant trends in ESG, Technology and China’s development. To broaden exposure, funds are available that address these wider trends.
In case of a minor economic upturn in the new year, small-cap stocks are worth consideration. The reason is that smaller companies benefit disproportionately from a growth trend and tend to be less impacted by higher yields.
Since heavyweight stocks in global markets are over-priced, look at value markets such as China, Japan and Korea. These pose a lower level of downside risk.
Commodities help to diversify a portfolio and create a store of value as a hedge against inflation. It is essential during times of financial uncertainty.
The use of precious metals in technology industries has grown exponentially in recent years. As a result, the range of metals required for speciality alloys has widened significantly to include platinum, palladium and iridium. The list of investment options in precious metals now goes far beyond traditional market favourites such as gold and silver.
Alternative investments tend to be counter-cyclical to current financial market trends and provide an important balance for any portfolio. Diversification is important in current market circumstances. It can best be achieved by using a combination of investment tools including Private Equity (long term), Hedge Funds (shorter-term) and Private Debt & Trade Finance (60-90 days).
Private Equity (PE) offers shares in non-listed companies that are often at an early development stage. Such high growth opportunities require a significant risk-reward trade-off, as well as a long investment horizon and limited opportunities to access cash in case of market volatility.
Hedge Funds invest in traditional securities such as stocks, bonds and commodities. They aim to profit from rising and falling markets with both long and short positions. They retain a useful niche for investors prepared to lock up funds for a significant period and willing to accept the risks inherent in aggressively leveraged returns.
Where to turn for yield
Private debt or loans from non-bank institutions offer a vital alternative to bank lending to support business expansion when funding is in short supply. One of the most accessible forms of private debt funding is Trade Finance which provides a convenient way for SMEs (Small and Medium-Sized Enterprises) to raise working capital.
One of the products available in the trade finance space is Invoice Discounting. Investing in invoice discounting provides a sustained high yield because it is driven by a widespread need for liquidity among SMEs at all times. Due to a rapid turnover of invoices of around 60 days, investors also benefit from easy access to their cash in a short time frame
For private investors and institutions alike, trade receivables offer a steady rate of return even during periods of economic turmoil: they are short-dated. They are continuously repriced to reflect the possibility of increased default risk.
Online platforms such as Velotrade open the door to portfolio diversification. Furthermore, Trade Finance has a low correlation with equities and offers investors some portfolio protection in a market decline.