By David Urovosky
You may have recently seen or read news stories about the trend overseas toward central banks attempting to stimulate their countries’ economies by reducing loan interest rates to below zero percent. The European Central Bank (ECB) has already embraced negative yields, and the Bank of Japan is the most recent entrant into this controversial phenomena.
In layman’s terms, here is what you need to know about this trend and how it may affect your financial investments in the future:
What is a negative interest rate?
Negative interest rates are interest rates that are actually below zero. A depositor would actually have to pay money to the bank for keeping it there. In effect, the depositor is paying the bank to save their money.
This is how it theoretically works: If you deposited $10,000 in your bank you may only receive $9,990 after a year—with no interest paid in between. That means savers won’t get all of their money back. You may ask “Why would I do that?” As long as the rates were not too low or not too negative, you may keep it there and “pay the fee” for safety or convenience.
It seems counterintuitive that people would pay a bank or financial institution to save money. What is happening in the economy and financial markets in Europe and Japan that would make this option attractive to depositors?
This is not an attractive option for depositors. The Central Banks in Europe, Denmark, Sweden, Switzerland, and Japan are now charging commercial banks for their excess reserves. According to Bloombergview.com (January 29, 2016), negative interest rates actually punish banks that hoard cash instead of extending loans to businesses or to weaker lenders. They have not started charging retail customers (yet) for fear of losing deposits. By the end of 2015, about a third of debt issued by euro zone governments had negative yields. That means investors holding bonds to maturity won’t get all of their money back.
There are several potential explanations for the emergence of negative yields, particularly those on the short end of the yield curve. These include very low inflation, the persistence of the international savings glut and “flight to safety” toward low-risk, fixed-income assets.
In consequence, sovereign bonds of certain countries in Europe that are deemed low-risk have been in heavy demand. In addition, The ECB has exacerbated the demand for these bonds by implementing the Extended Asset Purchase Program (their version of quantitative easing — stimulating the economy by increasing funds in the monetary system). The ECB is purchasing $60 billion of these bonds every month until at least September of 2016 for a total of $1.6 trillion euros. This and other factors have caused a shortage of these bonds, which has driven up the price and knocked down the yields into negative territory.
What is the likelihood that American banks and other financial institutions could start charging depositors to hold their money?
Most banks have not passed on this cost to their retail customers for fear of losing deposits. However, this policy does cost the banks money and hurts profits. The banks have tried to cover some of this cost by implementing various fees. Some commercial banks, such as Julius Baer and JP Morgan, have started to charge their largest corporate customers who carry tens of millions of dollars with the banks. In effect, they are telling these larger customers to take their money elsewhere!
For the average individual investor, what are the plusses and minuses of negative interest rates?
The big plus is that is that interest rates for loans of all types—mortgages, car loans etc.,— will be lower for a longer period of time. It will be a great time for borrowers. The same holds true for our government. With $19 trillion in debt, interest rates will remain low and our deficit will not increase at blinding speed. Businesses will be able to borrow at lower rates and expand. Companies will be able to borrow cheaply and either expand or buy back their stock (such as Apple and many other companies).
The minuses of negative interest rates are two-fold. It is bad for savers and that affects a lot of retired people. It may have a cost to keep money in the bank. The second is behavioral. If interest rates were only slightly negative, it may not change behavior very much. Depositors would still leave money in the bank for safety and convenience. But negative rates crossing that threshold (some analysts say at 0.5% negative) could change behavior. How?
- People may start to make excessive tax payments to the government and earn a zero return until a refund is received from the government, thus avoiding negative rates.
- People may start to pay their electrical bills or cable bills months or even a year in advance.
- People may also start to hoard cash and leave it under their mattress.
None of these tactics are good for the economy. The economy is based on confidence and we need money in the system to be “out there” changing hands, and making purchases. In his February 13, 2016 article “Negative 0.5% Interest Rate: Why People are Paying to Save” in the New York Times, financial reporter Neil Irwin muses, “Might new businesses sprout up that allow people to securely store thousands of bundles of $100 bills, or could people buy physical objects as stores of value that banks can’t charge a negative interest rate on?” In Japan, where rates have been very low to non- existent and now negative for a long time, many people buy safes to keep in the house. Maybe we should start looking for companies that manufacture safes as an investment?
What are the spinoff implications of negative interest rates for other financial market sectors?
For countries that have implemented negative rates, it may help boost their exports by encouraging currency depreciation and may support lending and domestic demand by further easing credit conditions. At the same time, they could also have some adverse consequences for financial stability through an erosion of bank profitability and through excessive risk taking by investors seeking a higher yield (as mentioned in my last quarterly report).
Potential implications for developing countries include a search for yield supporting capital inflows (for example, U.S. treasury bonds would become a very attractive investment compared to the bonds in sovereign debt of Europe because the treasuries are high yielding and the dollar would increase in value as compared to the euro), which could help offset the impact of an approaching liftoff in U.S. policy interest rates.
As far as currency goes, if our interest rates are higher than Europe and Japan (which they are now), investors searching for yield will buy these bonds. They are attractive. They are priced in U.S. dollars, so theoretically the dollar will go up in value as compared to the euro and the yen. This will make U.S. products more expensive around the world and will hurt sales and earnings of the large U.S. companies that have a lot of international sales. That is one reason the stock market took a big hit when Janet Yellen announced the first interest rate hike in almost 10 years in December 2015. Much of the rest of the world is lowering rates as we have started to hike rates. That hurts our multinational companies earnings and profits and share prices.
Your key takeaways:
I don’t think we will have negative rates in the United States this year; however, negative interest policy is spreading in the rest of the world. David Kotok, the Chairman and Chief Investment Officer of Cumberland Advisors said, “Five currencies and 23 countries are now practicing some form of negative interest rate policy (NIRP). In all cases the likely outlook is for NIRP to go lower in rate and for its usage to broaden. For perspective, 24% of the world’s real output is housed in those 23 countries ranging in size from Malta (the world’s smallest economy) to Japan (the world’s third-largest economy).”
I expect interest rates in the U.S. to remain low for a long time, perhaps 3 to 5 years. Investors will continue to search for yield and, with a lack of other choices, I think money (in fits and starts) will find its way to the stock market and other risk assets and drive prices of credit-sensitive bonds and stocks higher during the next few years.
Questions or comments? Send us an email at David.Urovsky@lfg.com.
The information in this blog post has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of David A. Urovsky, President of Wealth Advisors Group, and are not necessarily those of Lincoln Financial Advisors. Expressions of opinion are as of this date and are subject to change without notice. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. Investments mentioned may not be suitable for all investors. Investing involves risk, and investors may incur a profit or loss.
David Urovsky is registered representative of Lincoln Financial Advisors Corp. Securities and investment advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer, Member (SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. It is not our position to offer legal or tax advice. Wealth Advisors Group is not an affiliate of Lincoln Financial Advisors Corp. CRN-1468262-041116
Keys to Risk-Adjusted Portfolio Management
By David Urovsky
Not every investor has the same tolerance for risk, which is why risk-adjusted portfolio management is so essential in today’s volatile market.
The risk-adjusted investment approach starts with a clear understanding of the client’s risk tolerance and investment goals. Investment recommendations are initially constructed to match the client’s unique risk level and then carefully monitored to help keep the portfolio on track toward meeting the client’s goals.
Monitoring portfolio risk level
Risk tolerance is often directly related to a person’s experience with investments. For example, somebody who experienced the tech crash of 2000 – 2002 or the financial crisis of 2008 – 2009 is going to have a different perspective on investments than somebody who is coming into the market for the first time or who only has a couple of years of experience.
Time horizon is also a factor in a client’s risk tolerance. For example, a 40-year-old saving for retirement can be more growth-oriented than somebody who is nearing retirement and is going to need their portfolio to provide income.
Takeaway: At the most fundamental level, risk-adjusted portfolio management requires continuous monitoring of the portfolio’s risk level in light of market conditions. In 2016, I don’t expect great growth in the economy. I will be looking for investments that pay dividends.
There are times to take risks and times to wait for better opportunities
Looking back to 2015, with savings accounts or money markets paying less than 1 percent, many investors reached for higher yielding investment vehicles such as high-yield bonds, master limited partnerships (MLPs) and real estate trusts (REITs). Unfortunately, these investors ended up losing a fair amount of principal. As a result, in this uncertain economic and growth environment, you have to be careful not to try to force getting higher rates of return. You have to almost take what the market is giving you. There are times to take risks, and there are times to keep the powder dry, so to speak, and wait for better opportunities.
Little movement in asset classes in 2015
Another key factor in risk-adjusted portfolio management is understanding the correlation between investment/asset classes. Every portfolio must include different asset classes so that they don’t all move up or down at the same time. For example, Treasury bonds have a low correlation with the stock market. At the same time, correlation of high yield bonds with the S&P 500 and other stock indexes is much closer.
As it turned out, 2015 was an unusual year in that asset allocation didn’t help very much. Asset allocation is a strategy focused on how to invest among broad asset classes. The purpose of asset allocation is to control risk by reducing volatility or relative fluctuations in a portfolio thereby optimizing total return (investment returns, dividends and income). Asset allocation won’t guarantee a profit or ensure that you won’t have a loss, but may help reduce volatility in your portfolio. At the same time, diversification cannot eliminate the risk of an investment loss.
In 2015, most asset classes lost value or gained very little. Does that mean asset allocation no longer works? Of course not. Asset allocation is geared to long term success, and just because it didn’t work last year is no reason to discard it altogether. Asset allocation succeeds when it is part of a consistent investment approach over a long term, as opposed to chasing what’s hot today.
Takeaway: What is the key takeaway when it comes to risk-adjusted portfolio management? There are many different types of risks that an advisor reviews when putting together an asset allocation and selecting investments for the client. After all, we are trying to make money for the client. In order to do that on a consistent basis, each portfolio must be customized to reflect the balance between risk and return that the client will accept.
An advisor’s definition of success
Ultimately, our goal is to get better rates of return than the level of risk we have taken. From an advisor’s standpoint, that is our definition of success. When it comes to the client, success is invariably defined by the degree to which their portfolio meets their financial goals.
Questions or comments? Send us an email at David.Urovsky@lfg.com.
David Urovsky is registered representative of Lincoln Financial Advisors Corp. Securities and investment advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer, Member (SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. It is not our position to offer legal or tax advice. Wealth Advisors Group is not an affiliate of Lincoln Financial Advisors Corp.
Hallmarks of a Client-Centric Investment Approach
By David Urovsky
Knowing the client. That is what a client-centric investment approach is all about.
An investment advisor’s work process must begin with the client. The advisor must take the time to really get to know the client as an individual. In the first meeting, the advisor should ask about the client’s current financial circumstances. Factors to review include annual income, job security and satisfaction, and financial assets set aside for retirement or other financial objectives. Then the advisor and client should discuss anticipated financial goals and the time horizon the client has in mind.
Based on a careful study of this information, the advisor is then able to develop a customized financial plan that offers several approaches to investment – all of which are clearly defined, manageable and responsive to the criteria the client has provided. After the client selects the approach that seems most appropriate, the advisor finalizes and exacts the plan, choosing carefully from the vast array of financial products available in the marketplace.
Day-to-day, the client-centric investment approach is demonstrated through attentive service that includes returning phone calls and e-mails promptly (on the same business day). And sometimes, the advisor goes above and beyond.
For example, a couple of weeks ago, I went with a client to help her buy a car because she wasn’t familiar with all of the financial terms and jargon. Next week, I’m going to sit with a client and her attorney to discuss alimony disagreements with her ex-spouse.
Client-centric portfolio management also means being proactive with regular and frequent client communication by phone, e-mail, mail and, if appropriate, in-person meetings.
Consistent portfolio review is another hallmark. Depending on the client’s preference, portfolio reviews could be quarterly, semi-annual or annual. Whatever the frequency, these reviews must be done consistently. They can be done in-person or by phone, depending on the client’s preference. Either way, consistent portfolio reviews make it possible for the advisor to respond more effectively to changes in the client’s life or market conditions.
Perhaps the most important hallmark of the client-centric investment approach is that all investment solutions are customized and personalized. This means strict avoidance of cookie cutter solutions or pre-packaged investment models.
In the long run, client-centric investment depends on the quality of personal relationships. As an advisor, I’m not just a stranger who manages money. I make it my business to be accessible to my clients. In that spirit, I have been known to make house calls.
David Urovsky is registered representative of Lincoln Financial Advisors Corp. Securities and investment advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer, Member (SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. It is not our position to offer legal or tax advice. Wealth Advisors Group is not an affiliate of Lincoln Financial Advisors Corp. CRN-1408432-020216