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GW&K Investment Review 4Q 2020

Harold G. Kotler, CFA

Download the Year-End Investment Review to read comments from our investment teams.

ECONOMIC COMMENTARY

What if interest rates stay at 1% for an extended period of time? What if inflation lies dormant and deficits keep growing and debt as a percent of Gross Domestic Product (GDP) pushes past its present level of 100%?

I have argued for years that in a competitive global environment there will be little to no inflation, as there are enough resources and capacity in the world to maintain equilibrium. With the pandemic, however, a new argument has emerged—that all the money created by the extraordinary government intervention will be the new catalyst for inflation. But why would this be true? What if much of the liquidity is hoarded, dampening the multiplier effect? What if the money stays in banks or just finances government debt?

What if there is too much “money” chasing too few opportunities? Could this excess liquidity drive up values of other assets? There is an important need for predictable and reliable returns among institutions: insurance companies with their underwriting assumptions, colleges and foundations with their base spending requirements, and pension plans with their need to meet contractual obligations. But given the low interest-rate environment, this group may be forced to invest more creatively in a wide array of investments.

The fact is, many institutional investors have been increasing, not decreasing their allocation to bonds. Why? Because they are uncomfortable with volatility and equity valuations. But the reliance on bonds for an important component of portfolio returns almost guarantees that contractual obligations to pensioners, policy holders, and trustees will fall short.

As much as low interest rates hurt bondholder returns, they also allow the government to finance its ever-increasing debt at minimal cost. If those rates were to shoot up, the government’s cost of servicing the debt could threaten its ability to meet other discretionary obligations. With a debt load of $21 trillion and rising, a 1% across-the-board increase in rates could drain billions of dollars from the budget that had been allotted for other purposes.

Hopefully one can see the “Catch-22.” Higher interest rates would help investors, but devastate the government’s budget and increase the overall pressure on the general economy. Low interest rates would hurt those dependent on safe assets as a source of meaningful cash flow. Investors may be forced to revisit their present asset allocation and evaluate different approaches to balance the tension between volatility and opportunity.

The good news is that the global economy will continue to grow. As more citizens of the world pursue a middle class life, they will reap the benefits of better healthcare, lower pollution, and more job opportunities. There is no chance that they will be satisfied with less. Whatever form of government may rule a country, the need to deliver on a better way of life reigns supreme. The pandemic has reinforced the realization that we all share one globe.

In some ways, the COVID-19pandemic reminds me of the nuclear confrontation fears in the 1950s—they both serve as a reminder that we all inhabit the same planet. We find ways to live together or face mutual destruction. Nations are inherently linked. It is the same now as it was then.

Future investment returns will most likely be earned very differently from the past, as fixed-rate bonds may no longer provide returns consistent with prior assumptions. Bonds will still represent a store of value and a hedge against dire outcomes, but the need for an acceptable return warrants a more diversified portfolio. To achieve this one needs to consider adding illiquid assets to liquid assets and adding foreign securities to domestic securities—the willingness to leave the accustomed safety of our shores. The fear of investing in foreign assets and the belief that the U.S. is the only place for safe and predictable returns will prove to be a mistake.

One positive impact of this pandemic is that it has pushed us all to reflect on how we live our lives and operate our businesses. Companies that have adjusted quickly and moved in a more tech-savvy direction have been able to grow. The ability to recognize the winners coming out of this period may need an expanded logic. If interest rates do stay at or near zero, investors will likely give new companies more runway to develop products. After all, nothing inspires patience like an alternative return of 1%, even if it is “risk free.” Time will tell, but it is hardly inconceivable that current equity valuations are more than fair, and the combination of technology and low interest rates push asset prices higher both here and abroad.

With the prospect of low inflation, investors and individuals need to understand the new paradigm of risk/volatility/return. There is little doubt that volatility will generate anxiety, but diversification, patience and steadfastness will be a successful formula.

With a new year, brings new hope. We have a vaccine, a new government, and a world at peace. Stay well.

Harold G. Kotler, CFA
CEO, Chief Investment Officer

This represents the views and opinions of GW&K Investment Management and does not constitute investment advice, nor should it be considered predictive of any future market performance. Data is from what we believe to be reliable sources, but it cannot be guaranteed. Opinions expressed are subject to change. Past performance is not indicative of future results.

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