Cover Story: Investing in the new abnormal (Part 1)

Published on The Edge Markets (http://www.theedgemarkets.com)

Aug 10, 2016 | Written by Tho Li Ming | 0

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on August 1 - 7, 2016.

IN the past 18 months, the European Central Bank (ECB) as well as the central banks of Japan,
Denmark, Sweden and Switzerland have cut key interest rates to below zero to spur growth. This
unprecedented use of the negative interest rate policy and its growing prevalence are a causing a
rethink in investment and retirement strategies across the globe.
The key objective of this policy is to boost growth, but it does not seem to be working. In Japan, the
loan growth of banks was at its slowest in the last three years in March. Deposits, however,
increased 3% during the month, slightly lower from 3.1% in February.
The most obvious anomaly is how the yen responded to the Bank of Japans (BoJ) January
announcement that it would cut interest rates to negative. Instead of weakening, which would spur
growth, the currency strengthened.
Vasu Menon, vice-president and senior investment strategist at OCBC Singapore, says this
phenomenon occurred because many considered the yen a safe haven amid the uncertainties in
China. Instead of weakening, the yen shot up because the move was smack in the middle of the
crisis in China and the renminbi was weakening. If you have uncertainties around the world, people
just gravitate towards the yen as a safe haven.
Sometimes people regard it as being even safer than the US dollar. In fact, the yen is one of the
best performing currencies in the world. This makes it difficult for Japan to really make the negative
interest rate policy effective.

Impact of negative bond yields

Negative rates have also had a bearing on bond yields globally. According to Bank of America Merrill
Lynch, the amount of negative-yielding debt rose to a record US$13 trillion after the Brexit
referendum on June 23, from US$11 trillion before the vote and almost zero in 2014.
Kristina Fong, economist and head of research at RAM Rating Services Bhd, says the pronounced
downward pressure on global bond yields has been largely motivated by the expectation that Brexit
would exacerbate the already-low interest rates in developed markets.

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Cover Story: Investing in the new abnormal (Part 1)

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In particular, investors are seen to be pricing in a further delay in the Federal Reserves raising of
US interest rates and additional monetary stimulus by the Bank of England and the ECB, to support
economic growth on account of Brexit. Nevertheless, Malaysian bonds were a beneficiary of the
event, says Fong.
The days following the vote were characterised by aggressive yield hunting on the part of global
investors, which saw a significant net inflow of foreign investor funds into the Malaysian bond market
to the tune of RM5.7 billion in June, bringing foreign investor bond holdings to a 19-month high of
RM235.2 billion.
She says this was unlike the trend observed in other episodes of global volatility and uncertainties in
the past. What makes this episode distinct from previous ones is the largely prevalent negative or
zero interest rates and negative bond yields, which were absent before.
The taper tantrum in 2013 and Chinas sudden currency devaluation and stock market flash crash
of 2015 elevated Malaysia Government Securities (MGS) yields and saw a decline in the foreign
holdings of domestic debt securities, says Fong, adding that global volatility will continue in the
second half of the year.
Negative yields will create a volatile bond market, as investors will not be motivated to hold on to
the securities until maturity. As a consequence, Dr Yeah Kim Leng, professor of economics at
Sunway University Business School, says the bond market will be subject to higher risk. At the same
time, people are looking at higher-yielding bonds, which carry higher risk. That is something
unprecedented in the bond market. If inflation continues to be low, then the risk of investing in
bonds will be lower.
Teh Chi-cheun, CEO and executive director of Pacific Mutual Fund Bhd, believes governments will
continue to utilise this tool at least for the next few years. We have only seen negative interest
rates since the global financial crisis, and that is not even a decade old. Japan just introduced
negative interest rates this year while the ECB went deeper into negative territory.
Hence, for the impact to be effective, negative rates will have to remain for the next two to three
years, easily. For Japan, as it only introduced negative interest rates this year, it will likely continue
for a longer period compared with the ECB.
This environment raises concerns about the future of the already fragile global economy. It will also
incite investors to take on additional risk to compensate for the lower rate of returns from assets as
the traditional risk-return trade-off is no longer applicable. This poses a dilemma for pension funds
and insurance companies whose mandate is to invest in lower-risk assets, says Menon.
Pension funds and even insurance companies that need to put their money to work cant because
typically some of them have to buy bonds. Many bonds that they buy are the safer ones [which
today are] yielding negative interest rates.
So, pension funds are scratching their heads wondering how they are going to put their money to
work. If rates are -0.1% to -0.2% and they cant go into risky assets, they may have no choice but to
move up the risk ladder so they can get better returns.
This may not be a good thing because they may be taking undue risk. So, they go into private
equity, into high-yield bonds, which may be good and bad, because they were not designed to do
these sort of things.
It may not be positive for growth. Menon says when consumers know that their money is not going
to grow very much for the next few years, the only way for them to grow it is to save even more than
before.
This applies especially for those building their nest egg for retirement. If interest rates were higher,
it would help them grow their money. So, instead of using this policy to boost spending, it may
prevent people from spending and even encourage them to save more, he points out.
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Cover Story: Investing in the new abnormal (Part 1)

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If this is prolonged, Teh says it can result in high risk for the entire financial system without adequate
compensation of returns. These negative interest rates can push investors to take on additional risk
due to the lack of yield. At some point, these policies will lose their efficacy and the confidence of
investors.
There is evidence that this already happening. Danny Chang, head of managed investments and
product management at Standard Chartered Bank (M) Bhd, says the lower interest rates are fuelling
carry trade (borrowing at lower interest rates to invest in higher-yielding assets), which leads to
further yield compression.
With US dollar borrowing rates below 1.75% per annum, investors are borrowing in the US dollar
and investing in yielding assets that pay income above this level, such as high-yield and emerging
market bonds.
Yeah paints a starkly darker picture, saying it can result in excessive fear of a market collapse.
There is a certain point in time when the effects kick in, which can result in an excessive fear of
market collapse or worse still, a surge in demand when people suddenly realise that the money is
becoming worthless and start chasing yields as a hedge against inflation.
The potential for asset bubbles becomes very likely. So, the risk is always there for market
disruption, especially when there is so much liquidity in the financial system.
Negative interest rates are not the only issue. Many central banks have reduced their key interest
rates, including Bank Negara Malaysia, which lowered its overnight policy rate (OPR) by 25 basis
points to 3% in mid-July, citing concerns about the Brexit fallout. The move surprised many
economists and industry observers.
Investors will have to brace themselves for such market events, says Yeah. [Negative and] low
interest rate policies are going to create a lot of market swings, so investors will have to brace
themselves for them, whether in bonds or equities. If there is a further cut in interest rates and
quantitative easing, it can build up to a situation that creates an overreaction. Markets tend to have
tipping points, which are really unknown at the moment.
Others do not think a financial crisis will be triggered by negative interest rates alone. While not
discounting the possibility, Affin Hwang Asset Management Bhd chief investment officer David Ng
believes a crisis could be triggered by a convergence of events, such as a surge in inflation.
On the fixed income side, there could be a significant pullback if there is a growth scare. At this
juncture, it looks unlikely. But if for some reason, growth starts to pick up fast, inflationary
expectations start to turn around globally, then you will see yields reverse, he says.
If there is a very certain acceleration in expectations, the equity market in emerging markets could
see a pullback because of a stronger US dollar immediately. But if growth continues, then it should
favour equities and growth assets.
But with so much money ploughing into fewer assets that can deliver satisfactory returns, prices of
assets will continue to inflate, creating the risk of unsustainable bubbles that are set to burst with
serious repercussions. Is there a real risk of this happening?
Menon does not think so. You do have money flowing in the higher yield segment of the bond
markets, but I dont see money rushing in senselessly in a widespread manner.
There has got to be irrational exuberance [before a bubble is created]. We do not have that right
now. In fact, you have a lot of scepticism. If you look at many parts of the world, fund managers are
cashed up and individuals are sitting on a lot of cash and waiting for tactical opportunities before
going in to buy, and then cash out [later].
While you cannot discount the probability of a 10% to 15% pullback, I do not see markets crashing
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Cover Story: Investing in the new abnormal (Part 1)

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because there is so much money on the sidelines money goes in when you see pullbacks, which
then help markets rebound. That explains why you see so much volatility.

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