Over the past week, the market focused on the Federal Reserve’s meeting in Jackson Hole, Wyoming. While Chair Janet Yellen chose not to speak at last year’s meeting, this time her speech was eagerly anticipated. Yellen’s sound bites have become headlines with something for everyone, but “I believe the case for an increase in the federal funds rate has strengthened in recent months” is receiving significant attention. Nevertheless, the devil is in the details and this observation is simply not a promise of action. Furthermore, the speech in its entirety does not assuage investors’ desire for crisp, clear, definitive direction.
As interest rates have remained inside well-established ranges of historical lows, equity market indices are at or near their all-time highs. At the same time, this summer the world has witnessed the launch of ballistic missiles from North Korea near Japan, an ongoing military build-up in the South China Sea, a coup attempt in Turkey, and the continued tragedy of ISIS-inspired terrorism throughout the world. The list of economic concerns is also lengthy, with stagnant corporate earnings, anemic commodities prices, the unknown cost of Brexit, escalating non-performing loans in China, continued troubles in Europe’s banking sector, Japan’s struggles with Abe-nomics, and lower productivity globally. If these are the kind of macro and financial issues that typically create fear in markets, it is certainly not playing out that way.
Lower interest rates for longer was originally meant to serve as a cure for the anemic growth that followed the recovery, in an effort to stimulate borrowing and spending by consumers and businesses. Yet instead of significantly promoting growth, low interest rates seem to be distorting risk premiums and supporting asset prices. And after eight plus years of this medication, we fear the patient may be addicted rather than cured.
While members of the Federal Reserve indicate that every meeting counts, and they could raise rates at any time, the truth is far more complicated. As much as they might wish otherwise, their ability to normalize monetary policy is constrained by both domestic and global forces out of their control. In our view, one data point in particular illustrates this conundrum: over 25% of the world’s sovereign and corporate bonds now trade with a negative yield. That’s over $13 trillion in debt trading at yields below zero.
As global central banks have increased liquidity efforts to avert crises and spur growth over the past few years, unconventional monetary policy has given rise to the once-unchartered territory of negative interest rates. And in the measure of most central banks, the world is still too fragile, growth too slow, and employment gains insufficient to warrant the beginning of a reversal. Holding interest rates down is the primary tool these banks have to spur economic growth, and it is being used with vehemence.
In the U.S., gauges of unemployment and inflation, stabilization of which falls to the Fed, have resisted clear interpretation – as the incredible forces of technological change, demographics, and globalization seem to have disrupted traditional economic relationships. Yet with a good portion of global debt producing negative yields, the U.S. remains viewed as the least worst choice. We anticipate demand for U.S. debt is likely to remain in place, especially since foreign investors seem to have few adequate alternatives. As an external force putting downward pressure on rates, this demand is one of the headwinds facing the Federal Reserve.
For income investors in this environment, it remains a true challenge to generate a substantial and sustainable income stream – one high enough to meet income needs, without jeopardizing principal. Higher interest rates may begin to arrive sooner than later, but this could remain a prolonged process. In the meantime, we are not tempted to chase yield. We remain devoted to our conservative income-oriented approach in seeking to provide both high income and safety.
Source: Bank of America Merrill Lynch
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