Where to Invest When Interest Rates are So Low

Unlike most people who analyze investments, I think there are periods of time where domestic long-only investors may be consigned to low or even negative returns. As investors, we are generally optimists; we don’t like can’t win situations like the Kobayashi Maru.

When money market funds offer near-zero yields, asset allocation becomes complicated. Near the beginning of such a period, it might pay to take a lot of risk when credit spreads are wide. But when they are more narrow, but wide by historic standards, the question is tough.

I start analyses like this the way I do the the piece Risks, not Risk. I look at the individual risks and ask whether they are overpriced or underpriced. Here is my current assessment:

  • Equities — slightly undervalued at present, particularly high quality stocks. (US and foreign)
    • Credit — Investment grade credit and high yield are fairly valued at present.
      • Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties. There will be more defaults, both in commercial and residential.
        • Yield Curve — Steep. It is reasonable to lend long, so long as inflation does not take off.
          • Inflation — Low, but future inflation is probably underestimated.
            • Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
              • Commodities — the global economy is not running that hot now. There will be pressures on resources in the future, but that seems to be a way off.
                • Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

                  All that said, for retail investors, I am not crazy about the options at present. I would leave more in money market funds than most would as a part of capital preservation. I would also invest in high quality dividend-paying stocks, because they are undervalued relative to BBB corporates.

                  Beyond that, I would consider fixed income investments in the Canadian and Australian Dollars. I am skittish about the US Dollar, Euro, Pound, Yen and Swiss Franc. (The least of those worries is the US Dollar itself.)

                  We live in a world where risk is often not fairly rewarded at present, due to the liquidity trap that the major central banks have enter into. My view here is to play it safe when conditions are not crazy bad, and take a lot of risk when credit markets are in the tank.

                  As for now, I would hold high quality US stocks that pay dividends, US money market funds, and Canadian and Australian short term bond funds. Commodities and companies that produce them should play a small role as well.

                  About David Merkel 144 Articles

                  Affiliation: Finacorp Securities

                  David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

                  In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

                  Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

                  I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

                  Visit: The Aleph Blog

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