For Investors, the Future Is on Hold

06/22/2010 9:32 am EST


Jim Jubak

Founder and Editor,

What happened to the dire predictions of higher interest rates and inflation? Those may still happen, but here's how to adjust your investment strategy in the meantime.

Reality has a nasty way of throwing investors' assumptions onto the rubbish heap.

Take this one: The massive stimulus packages, central bank interventions, and government budget deficits will lead to a surge of inflation and rising interest rates.
That may still turn out to be true in the long run, but the long run is showing a disconcerting tendency to recede into the distance these days.

It's worth asking if the arrival of higher inflation and higher interest rates is now sufficiently delayed that the period between now and then deserves its own set of investing strategies. What kind of strategy? I'll try to lay out the general outlines of one in this column.

It's certainly a possibility worth taking seriously after the news of the past week or so. First, we've had a US consumer price inflation report that showed prices are going up so slowly that inflation is virtually nonexistent. (For more on the May inflation rate in the United States, see this post on my Web site.)

Second, we've had projections that show economic growth in the euro zone stuck at less than 1.5% for a considerable period because of a stubbornly persistent euro debt crisis and the budget cutting that is flowing from it. (See "The Real Cost of Fiscal Discipline" for more on how slow growth could get.)

And third, we've had a study from the Federal Reserve Bank of San Francisco that suggested US interest rate increases would be put off until 2012.

It's one thing to follow an investment strategy based on a trend that is projected to arrive at the end of 2010, and quite another thing if that trend is set to arrive 18 months from now.

The Future, Delayed

So, for example, if you think inflation is going to kick up strongly as early as early 2011, then it makes sense to buy gold and other commodity inflation hedges now. So what if gold doesn't pay any dividends or interest? So what if commodity prices won't go anywhere good if economic growth slows?

The payoff is close enough so that being early by a couple of quarters isn't too expensive.

But how about if higher inflation won't hit until sometime in 2012? The expense of being early is much greater when the waiting period is longer. And if economic growth is actually lower than expected for much of this period, then investors pursuing this strategy aren't just costing themselves interest and dividend payouts by being early, they're likely to take losses on their commodity hedges, too.

But the strategies that most require rethinking are those based on a belief in a relatively quick move toward higher interest rates as a result of the vast expansion of money supply created by massive government spending.

I'd break the need to rethink that assumption into two parts.

Part One: Developed Economies

It's increasingly clear that low interest rates will be with us in the United States, Europe, and Japan for a while, because economic growth is so slow and the recovery in these economies is so uncertain. Central banks in these economies aren't going to rush to raise their benchmark interest rates anytime soon, for fear of stalling any recovery.

This situation can't go on forever.

The long-term budget deficits in these countries can't—except maybe in Japan—be funded internally. That means interest rates will have to rise eventually to attract the overseas capital that these countries need. That can happen quickly, as it has with Spain, where yields on 12-month bills have climbed 0.7 percentage points—or roughly 40%—in the past month. Or slowly, as looks likely with the United States. But eventually those rates will rise.

It's just that "eventually" is further off than we had expected a year ago.

What are the consequences of this?

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The danger of higher interest rates decimating bond portfolios is still real, but it is more distant than we thought.

If low interest rates are going to be with us for a while, income investors who are planning to retire on portfolios of bonds and dividend stocks aren't going to find lots of opportunities to lock up the high yields they were counting on.

And if interest rates are going to stay at current abnormally low rates for longer than investors expected, yields that they once would have shunned as too low or easy to pass up will look really attractive.

In these developed economies, it means sticking with high-yielding master limited partnerships such as Oneok Partners (NYSE: OKS), at a 7.12% yield, and Magellan Midstream Partners (NYSE: MMP), at a 6.35% yield. It means giving serious consideration to stocks like Verizon (NYSE: VZ) or Total (NYSE: TOT), both in my dividend income portfolio, if they have a high yield (currently 6.52% and 5.57%, respectively), even if their growth prospects aren't stellar. It means giving serious consideration to stocks with growth potential as income vehicles even if their yields are just 3.61%, as in the case of Abbott Laboratories (NYSE: ABT).

Part Two: Developing Economies

Part of our earlier assumption about interest rates is in the process of coming true for these economies. The central banks of Brazil, Indonesia, and India are raising interest rates to put a stop to inflationary trends. In these economies, the timing of interest rate increases—mid-2010—is pretty much what we were anticipating for the developed world a year or so ago.

But part of our earlier assumption is turning out to be very wrong. Although interest rate increases are arriving on schedule in 2010, they appear likely to end much earlier than anticipated. Brazil, for example, could be done with its series of interest rate increases as early as this coming fall.

There are two reasons that interest-rate increases in developing economies are moving so much faster to an end than looked likely a year ago. First, central banks in these countries—with the notable exception of the People's Bank of China—have been emboldened by high domestic growth rates to move quickly and decisively to raise interest rates and stomp down on inflation. Many of these banks realize that their countries have made huge strides in impressing global financial markets with their financial discipline in recent years, and they seem determined not to take a step backward. Brazil, for example, has won its first investment-grade credit rating ever.

And second, the economic slowdown or sluggishness in the world's developed economies has made interest rate increases in the developing economies extraordinarily effective. Brazil's central bank, for example, has gotten a helping hand in damping the Brazilian economy from the slowdown in the country's European export markets. With that kind of help, central banks haven't had to force their patients to swallow the full course of medicine.

What are the consequences of this?

If developing-economy central banks put an end to their interest rate increases in late 2010 or early 2011, it means investors will be looking at peak yields in these financial markets with the prospect of steady or even, better yet, declining interest rates in later 2011 and onward. (Declining interest rates will push the prices of existing yield vehicles, with their higher-than-current yields, higher.)

Add the prospect of declining interest rates to a trajectory that suggests that, while credit ratings are falling in the developed world, they're rising in the developing world, and you've got a very real possibility of significant capital gains from developing-economy income securities.

I don't think you need to rush to buy those developing-economy yields quite yet. Central banks in those economies are still raising interest rates, and I think that gives investors some time to research those markets looking for yield.

And that is good. Because finding high-yielding stocks and bonds in those economies is hard and time consuming, especially if you want to get a handle on the risk of anything before you buy it.

I've got my eye on five possibilities right now. I'll report back when I've finished my research in the next few weeks.

At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at

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