Where are we in the search for yield?
Drivers of the search for yield
- First, low interest rates and bond yields and the flow on to bank deposit rates due to low inflation and sub-par growth have encouraged investors to search for higher yielding investments. Central banks buying up bonds and displacing investors into other assets have accentuated this.
- Second, reduced fear of economic meltdown (as the GFC and subsequently the Eurozone public debt crisis subsided) has helped investors feel comfortable in taking on the greater risk that this entails.
- Finally, aging populations in developed countries is seeing baby boomers move into pre-retirement and retirement, driving a demand for less volatile investments paying income. Normally, this demand would go to bonds and bank deposits but as their yields are so low some of this demand has gone into other yield paying investments.
The logic of falling yields
The search for yield is understandable and can be seen in relation to Australian commercial property ie office, retail and industrial property. The next chart shows average commercial property yields and 10-year bond yields. While average commercial property yields have fallen since the early 1980s from an average of 8.3% to around 5.5%, the yield on bonds has crashed. The longer the decline in bond yields has persisted, the more investors have expected it to continue, driving rising demand for higher yielding assets like property.
Source: Bloomberg, AMP Capital
With Australian 10-year bonds yielding 2.8%, it’s little wonder investors might find commercial property on an average yield of around 5.5% more attractive particularly once capital growth of, say, 2.5% pa (ie inflation) for a total return of 8%, is allowed for. The property risk premium – the return potential property provides over bonds – at 5.2% remains high & well above early 1990s and pre-GFC levels that caused problems for property.
Source: Bloomberg, AMP Capital
But are we getting close to a reversal?
For equities the gap between the forward earnings yield on shares and bond yields has narrowed in recent years. But this gap – which is a guide to the risk premium shares offer over bonds – still remains relatively wide by pre GFC standards.
Source: Thomson Reuters, Bloomberg, AMP Capital
- First, global growth is looking stronger as evident in strong business conditions indicators across most countries. Global growth is improving and becoming more synchronised globally. Nearly 75% of the 45 countries tracked by the OECD are seeing accelerating growth, the highest it’s been since the initial bounce out of the GFC in 2010.
- Part of the reason for this is that the “muscle memory” from the GFC, which commenced a decade ago, is fading and this is contributing to stronger confidence.
- The risk of deflation is receding and giving way to the risk of a rise in inflation as capital and labour utilisation is on the rise globally & productivity growth is poor, reflecting: low levels of investment; increasing levels of populist regulation in some countries; and as older workers retire. While the impact of technological innovation (the Amazon effect, artificial intelligence) will keep this gradual there will still be a cycle in inflation and the risks are gradually pointing up.
- Reflecting this, central banks are gradually retreating from ultra easy policy. The Fed is the most advanced here as the US economic recovery is further advanced. As a result, the Fed is moving towards allowing its holding of government bonds and mortgage-backed securities to start declining. This will be achieved by the Fed not rolling over (ie not reinvesting) the bonds on its books as they mature so it won’t be as dramatic as actually selling bonds. But its holding of bonds will nevertheless decline and it will be sucking cash out of the US economy. In other words, it will be undertaking “quantitative tightening” to reverse the “quantitative easing” of a few years ago. This is good news and reflects the strength of the US economy much as its commencement of rate hikes did in 2015. Nevertheless, combined with continuing gradual Fed rate hikes, it will likely see a resumption of the upwards pressure on bond yields acting as a gradual dampener on the search for yield.
What does it all mean for investors?
Dr Shane Oliver
Head of Investment Strategy and Economics and Chief Economist
About the Author Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.
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