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There have been numerous attempts since we emerged from the Great Recession in mid-2009 to attach a catchy moniker to this era of low growth, low rates and low returns. Two that quickly come to mind are Larry Summer's "Secular Stagnation" and Mohammed El-Erian's even more commonly quoted "New Normal”—but we would argue that we have seen something similar before, it just happened a long time ago.
Coming out of World War II, the US economy experienced what some have described as a “golden era” of expansion, built on the return of the soldiers, the maturing of millions of dollars in war bonds and the birth of the baby boomers. However, the numbers provide a different story. The US economy actually fell into a recession when the war ended in 1945 and suffered four more recessions between 1948 and 1961. The Federal Reserve intervened in the bond market during the war to keep rates low and afterward to help a struggling economy find its footing. The start of the Cold War and isolationist policies in the 1950s also contributed to a low nominal growth rate. This kept long-term interest rates in the 2.0%-to-2.5% range for more than a decade. Yields didn't move above 3% until 1957 (see chart).
Rates Follow Growth
While there are plenty of differences between today and the 1940s and 1950s, the low level of growth and interest rates is similar and makes an important point: Interest rates follow growth. If we are in an environment of slower, lower and subpar growth then we should expect interest rates to also remain low. That's not to say that for brief periods interest rates can’t buck the trend depending on geopolitical developments or policy mistakes. The "taper tantrum" in 2013 is a great example of this, when the 10-year US Treasury yield rose more than 100 basis points due to fear of the Fed tapering its bond purchases.
The reasons for slower US growth are well known: frugal consumers taking on less debt; companies being more cautious with their capital spending and balance sheets; and less government spending. The global economy has slower growth, too. In fact, the IMF expects 3% global GDP in 2016, roughly half the rate prior to 2008. In essence, there is a very low likelihood of either internal or external demand boosting growth above the current trend path of 2% real GDP.
Higher Yields Expected
We expect long-term rates to move higher during the next 12 months due to a modest pickup in US inflation and improved growth in Europe. That should narrow the gap between European and US government bond yields. However, any move higher will likely be limited by the level of growth in the domestic and global economies and could also be capped by liability-driven investors, such as pension funds, who will buy bonds at higher yields to help protect any gains in their portfolios. At some point, the US economy may grow at a more consistently high level and rates will move higher as well, but that seems unlikely for at least the next couple of years. As Morgan Stanley Wealth Management's CIO Mike Wilson said at a meeting recently, "This isn't the new normal. This is the old normal.”
Thus, we recommend putting money to work in fixed income markets with a more active approach. Municipals and investment grade taxable bonds can still act as portfolio ballast but likely won't generate much by way of return. The Global Investment Committee likes “equity like” segments of the bond market, such as high yield and preferred securities. They carry higher credit risk, but also higher return potential for at least the next six to 12 months.
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