UBS Asset Management: “There has been a fundamental downward shift in the equilibrium rate”

A new study paper from UBS Asset Management titled Disequilibrium argues:

• The shift lower of long-term interest rates and inflation was assumed to be cyclical and therefore capital market models have not been adjusted
• But a number of factors from changing demographics to lower capital investment and deleveraging point to structural change in rates
• A lower equilibrium interest rate leads to lower returns expectations for asset classes with major implications for investors

London, 31 May 2016 – UBS Asset Management today publishes its white paper Disequilibrium*, a major study on investing in the current low yield environment. In the white paper UBS Asset Management argues that the long-term equilibrium interest rate – the nominal rate, adjusted for inflation, at which the capital supply in an economy precisely meets capital demand to keep growth and inflation stable – has seen a fundamental shift downwards. This has significant consequences for investors, especially those with a required rate of return such as pension schemes or endowments.

In Disequilibrium UBS Asset Management contends many of the drivers for the fall in long-term interest rates is structural rather than cyclical as previously assumed. The paper argues a downward shift in the equilibrium rates needs to be factored into capital markets as a result of:

• Population growth: Japan’s population is now lower than it was in 2000 and growth is set to reverse in both the United States and China putting downward pressure on the natural rate of interest rates;
• Ageing populations: Of the G8 and BRIC countries, only India has a birth rate that remains above replacement rate. Ageing populations increase demand for safer, income generating assets further pressuring long-term interest rates;
• Deleveraging: Compression of bank balance sheets has led to lower lending growth, lower capital investment and lower economic forecasts and therefore lower long-term interest rates.

The implications for investors are twofold. Firstly, lower long-term equilibrium rates have significant implications for future monetary policy with the possibility of further unconventional policy measures raised. Secondly, investors with a required rate of return will be impacted and may need to consider the suitability of investments while Defined Benefit pension schemes face significant stress on funding status.

In response, UBS Asset Management calls for investors to respond by:

• Adopting a more unconstrained approach to their investment universe;
• Increasing flexibility around Strategic Asset Allocations;
• Focusing on managing downside risks by being nimble, flexible and liquid;
• Seeking to understand the benefits of diversification at a risk factor level.

Dawn Fitzpatrick, Global Head of Equities, Multi-Asset and O’Connor, UBS Asset Management commented: “We believe that an understanding of the long-term equilibrium rate of interest and its actual level is crucially important if we are to obtain a clear picture of the true implications of this low yield environment. Critically, a lower long-term equilibrium interest rate means that expected returns fall for all assets across the risk spectrum while expected risk stays the same.”