With silver bells and cockle shells, And pretty maids all in a row"
The ability for growth in the world's economy following the Great Recession can't quite be explained as easily as a classic nursery rhyme. 6 years on from the global financial collapse and we're still looking for many developed nations to prove that not only is the worst behind them, but that they're going to be on a strong forward trajectory for many years. Interest rates across the board are still at all time lows as the need for stimulus remains. Meanwhile volatility across many asset classes remain at levels below the average. With all these factors playing a part there exists a strong possibility that investors will seek to take even greater risks in the search for return.
Whilst there is talk is of a growing confidence in the economy across the US, UK and Europe, with this being reflected in many economic indicators, from a central bank perspective this is not yet the time to hint at any imminent rise in interest rates. The Federal Reserve is reducing the amount of stimulus it is pumping in by $10bn a meeting, but the fact remains it is still pumping QE into the economy with no talk of interest rate rises until at least 2015. The Bank of England, which many are anticipating will raise rates first, is also not predicted to do so until early 2015. Meanwhile the ECB has just opted to put the rate at which it charges banks to hold deposits into negative territory. Even when rate rises do occur over the coming years, economic forecasters are not anticipating base interest rates getting beyond 2% in the US (PIMCO speaks about this level even being the new 'neutral/normal'). The UK is unlikely to reach 3% before 2018 if even much more than that further then, and the ECB looks set to stick with extremely low rates for the visible future due to its low inflation, high unemployment and still struggling economies. All this assumes during this coming period that the economy doesn't suffer further economic turmoil forcing central banks to halt rate rises or reduce already increased rates at the time.
With rates remaining so low, those with savings and looking to invest are seeing ever diminishing rates of return. Savings accounts, even those with boosted 1 year rates, are only getting 1.5% if you're lucky. Meanwhile the alternative for investors wishing to keep their money in a safer investment but with some security such as core government bonds are seeing continuously reducing yields with the US 10 year at 2.56%, UK Gilts at 2.66% and Germany's at 1.38%. As investors try desperately to earn the kind of returns they require in order to meet both their short and medium term goals they have turned to ever more risky investments. The peripheral European countries' bonds which just 2 years ago were reporting yields in high single or low double figures are being pushed to prices which don't adequately reflect their extra risk. Portugal's 10 year is currently yielding only 3.6%, just over 2% above Germany's, whilst Greece's yield is down to only 6.12%, a quite expensive figure considering the country is still in the depths of a continued depression and further debt restructuring is likely. Even outside the government sphere into riskier corporate and high yield bonds has seen prices pushed up (and yields fall as a result) as investors go in search of investments to give them the kind of returns they are used to, without potentially adequate assessment of the quality and risk of the paper they are buying. In the meantime, while some stock markets continue to tick up (such as the S&P 500 in the US), the rate of increase appears to be on the wane, with other equity markets, such as the FTSE 100, remaining in and around highs but not breaching those levels any further, reducing returns investors can seek on these assets.
If the 'new normal' for the next 5-10 years is to see interest rates across the developed world remaining under 2.5-3% then it seems likely that more and more individual investors will seek to take more risks and effectively attempt to 'gamble' their way to retirement. The examples above show an already falling spread between more risky and safer assets but investors could be tempted to venture further into asset types which are beyond their true understanding. In the UK, especially in London, some investors who may have built up a sizeable but currently inadequate savings base, may be tempted to take advantage of the spiraling property market again. Whilst more safeguards are in place to ensure banks are only lending to those customers they deem "safer", the continuous rise in property prices, fueled in some way by the relatively affordable borrowing may convince banks and some of their customers looking for short term gains that no crash is imminent in the coming years whilst London still suffers from a housing deficit.
Retail investors may also seek to take advantage of leverage in other ways to multiply the small returns they can get on existing assets. There are many reports that margin loans (loans collateralised by borrowers investments) now exceed the levels pre-2008, whilst people may also seek to further benefit by releasing equity in their houses for use in investment, exposing themselves even further should house prices show a correction. There is also an ever increasing range of leveraged securities available for purchase by the retail investor. Why only get 1 times the return on the market when you can buy a leveraged ETF offering 2 or 3 times the return on an index? Whilst with the ETF purchase the investor will only lose the money they themselves invest, the ability to lose that money is enhanced because if the returns are leveraged on the way up, they're also leveraged on the way down, multiplying any negative returns.
The longer a period of low rates and returns exist there is also the risk that more and more less "sophisticated" investors will look to derivatives to boost their returns. This is already a factor in Japan where savers have seen the interest rates at levels close to zero for over a decade. Here it is most normal for individuals to go into their local bank and buy options on individual stocks or indices or ever more increasing complex structured retail investments. The government may seek to loosen the legislation on allowing regular retail investors (whether through pensions or individually) to purchase such products as it seeks to allow investors in such a low return environment to try better to meet their financial goals. Whilst I'm a firm believer that the use of derivatives by the individual retail investor is not specifically a bad thing in part of their portfolio, as I've mentioned previously, it's the lack of understanding that is the issue. This could cause many investors who are seeking to boost their returns to actually end up in a more perilous financial situation, negating the potential benefits and actually leaving further people dependent on the state at the time of retirement.
This isn't to say that any of this is inevitable. But as rates stay low and, as a result, the rate of return available to investors on regular products reduces, and remains low for a substantial amount of time, more and more investors will search for ever more risky and less understandable products to reach the financial aims they've set themselves. As a result the risk of loss and the consequences for a wider portion of the population increases. The truth is, if the existing low rate environment is likely to remain for the foreseeable future, we may also have to seek to reign in the financial goals we would normally look to achieve when the regular ability for higher returns were available to us. For those of us in the earlier years of our working lives it also emphasises the need to start saving (and investing) early enough for the future and not wait until we're in our late 30's or 40's to start a regular and sufficient pension pot. Our gardens may not grow as high Mary's, but we also need to make sure we act in the most sensible way to avoid the potential need to gamble it all away through ever increasing risk taking.
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