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Asset Classes that Perform Best and Worst with Negative Real Interest Rates

Markets
0 min read

Image Credit: Kim Alaniz (Flickr)


With Negative Real Rates, What Sectors Have Historically Outperformed?

The “real interest rate,” is defined as the net amount earned less inflation on an interest bearing security. Real rates are now at a low the country hasn’t experienced since just after World War II. In fact, with the recent Consumer Price Index (CPI) spike to 8.5% from a year earlier, inflation is 6% to 7% higher than one year US treasury levels. This means the real return is a negative 6% to 7%.

When the more conservative investor using interest-bearing securities begins to see inflation outpacing their investments, as they are now (in most cases), they recognize their assets are losing buying power. Their investments are not paying enough to keep up with price rises and certainly not growing so they can be able to buy more later with their savings. These simpler investors, by holding on to treasury securities, CDs, or corporate bonds, are losing ground, this loss of usable wealth begins to cause investors to move down the risk curve.

Putting on Risk

Dr. Horstmeyer is a professor of finance at George Mason University’s Business School in Fairfax, Va. He and his team decided to collect hard data on this phenomenon and see how different asset classes perform when real interest rates turn negative and stay negative for a while.

What they found with their look back is that when real interest rates turn negative, the asset classes considered riskiest (emerging-markets stocks, small-caps, etc.) had done extremely well in the first half of the inflation/interest rate cycle. During this period, they outperform what’s considered safer assets by over 1.5 percentage points a month. Stretched out over several months with compounding, the investors have done well.

The performance benefit reverses to a degree for those invested in these assets into the second half of the cycle. On average, the riskier assets have underperformed by over a percentage point (monthly) in the second half of a negative-real-rate cycle. This does not suggest the investors fared worse by adding risk to their portfolio; it may indicate that many investors were prudent and did not let greed keep them in the riskier securities. The later investors exiting lost ground from earlier gains.

The Research

To investigate what happened in the past, Professor Horstmeyer and his research assistants Jaehee Lee and Natalia Palacios gathered interest-rate data (based on T-bills), inflation data, and mutual-fund-return statistics for various asset classes over the past 50 years. They examined periods since 1971 when real interest rates turned negative and stayed negative for more than a month.

The group identified seven periods like this – the average period length is 2.5 years. For each period, they labeled the first half and the second half. The researchers then compared performance; first half compared to second.


What Investors Should Note

They reported two findings that investors should be aware of. First, during the first half of a negative-rate cycle, the riskiest mutual funds performed best. Emerging-markets funds, US small-cap funds and international-stock funds averaged 1.96%, 1.13%, and 1.03% returns a month, respectively. This average monthly return is far superior to all other equities and far better than the average bond fund, which had average returns of 0.35% a month during this period.

Half-Way Point

The additional performance reversed as the cycles matured. In the second halves, the riskiest funds underperformed. For example, emerging-markets funds lost an average of 1.13% a month. So while investors were seeking risk in the first half, it appears they eventually faded away from it the longer as the US remained with a negative real interest-rate environment.

Where are We Now

According to their findings which is based on historical averages, the current negative-rate cycle began in the second quarter of 2020. This could mean, if the 50 year pattern holds true, many investors have shifted over to riskier assets already. Since we are still sitting with negative real rates in the cycle, approaching the third year, it’s impossible to know yet where the first half ends and the second begins. Thus, even if we haven’t fully hit the point where investors move out of riskier positions, judging by historical length and data, we’re likely close.

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://www.bls.gov/cpi/#:~:text=CPI%20for%20all%20items%20rises,12%20months%2C%20not%20seasonally%20adjusted

https://www.wsj.com/articles/investment-negative-interest-rates-11651781476?mod=hp_jr_pos1

 

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