The Impact of the Low Interest Rate Environment

"And he's up there, what's that? Hawaiian noises? Bangin' on the bongos like a chimpanzee
That ain't workin' that's the way you do it, Get your money for nothin' get your chicks for free" - Lyrics from the Dire Straits song Money for Nothing

The low interest rate environment continues on and it is having a large impact on your portfolio and most of you do not know it is happening or understand why and those that do are hoping for an end to this soon.  It is no secret that this low interest rate environment is here for a long time to come so be prepared and look outside the box. 

The idea behind low interest rates is that it stimulates the economy for the simple reason that it entices people and business to take on debt (as the interest rate is low) and invest their savings.  Both of these stimulate industry and consumer demand which results in GDP growth and a buoyant economy. 

Now what happens if this does not work (as is the case right now)?  After the initial success of staving off the next depression the continued low interest rate environment is now taking a large bite out of your portfolio returns.  A low interest rate environment will at first benefit most in that it reduces the monthly payments on your credit cards and mortgage payments.  Businesses are able to borrow at cheaper rates leading to higher profits.  In addition, investors seeking return pile into the stock market in order to lock in good yields and to take advantage of stock price appreciation as companies benefit from increased earnings due to lower debt payments. 

In a simple example assuming that an investor has a choice between bonds and stocks.  As an aside when I read Bloomberg magazine a few weeks ago, other than cash these were apparently the only two options to investors!  And for most investors these are the only three options for your investment dollars (sad but true).  So back to the example, if interest rates are high then an investor should choose the bond for two reasons; the risk reward profile is probably skewed to the bond, and if history is any gauge, interest rates will fall at some point in the future and the bond price will appreciate.  So you earn a good coupon payment and capture bond price appreciation.  The asme happens in the stock market.  When interest rates drop, the investor shuns bonds and moves the money into stocks to take advantage of the higher yields and the earnings growth.

Essentially this is what has happened to date.  Bond prices went through the roof and bond yields collapsed.  The stock market rallied and has continued to rally ever since.  Looking forward however, interest rates will remain low for years to come so now where to turn?  As I have said repeatedly before we are in a very high risk investment environment.  Taking a look at Japan you can see that in an environment where interest rates remain low for a long time (two decades and counting) it is normally due to a weak economic environment.  In a weakened economic environment there is no requirement for the price of stocks to continue to the moon.  At some point people wake up and look toward the safe play, shunning stocks and this is what is happening now.

Every month more and more money pours into money market and bank deposits.  Safety is being sought but inflation is eroding their portfolio faster than they realize.  Essentially the Federal Reserve is taxing the prudent and forcing investors to make irrational bets.  This is the big risk.  Do not let the idle money burn a hole in your pocket .  There are plenty of good investments out there that do not require you to rush in sight unseen in order to try to elicit a return.  Furthermore while inflation is a portfolio killer it is slow.  Rather take a 5% hit through inflation than a 25% hit by making an irrational mistake.  Do not get caught up in the hype and expand your investment horizon beyond these two investment classes as that is where the returns are coming from now and for the foreseeable future.