Decade after decade over the last hundred years we experienced what is now often referred to as a “normalized interest rate environment” offering a real return (beyond inflation) with very little risk of principal. You may have taken for granted at the time that cash in a money market “should” earn 3% – or even 4% to 5% – because in the thirty years leading up to the mid-2000’s, it generally did.

Now money markets and savings accounts earn … nearly nothing. You take no principal risk, and you get nothing in return. Banks and brokerages would historically pay for deposits so they had capital to lend out at higher rates – but in today’s world we have an excess supply of money courtesy of the Federal Reserve, which has meant a long trend in lower and lower interest rates.

We have positioned portfolios awaiting reversal of this distorted environment, with cautious allocation and hedges in place, but that reversal hasn’t come. There was a tumultuous start to the year globally; concerns about falling oil prices, a rising dollar, and a weakening Chinese economy created a potent mix of worry, in which interest rates dropped again fairly dramatically. Stock prices recovered by the end of the quarter, though, with lower interest rates in place and despite a big jump in gold.

…we have an excess supply of money courtesy of the Federal Reserve, which has meant a long trend in lower and lower interest rates.

In a way, we saw an entire market cycle play out in the first quarter, highlighting how our investment strategy can perform when both stock market declines and rallies are present, and overall we have been pleased with your portfolio performance. Across our diversified client portfolios we saw average performance that slightly outpaced the S&P 500 while experiencing less volatility.

Global interest rates continued their downward trend. The Japanese Central Bank took their short-term policy rate negative at the end of January, and in the US, a rising dollar supported a decline in the benchmark 10 year Treasury note, with a dramatic drop from 2.27% at the beginning of the quarter to 1.78% at the end of March. In your performance reports, you’ll see that the bond market benefited, broadly increasing by 3% and turning in the best price performance of the indices that we track.

A cornerstone of the finance industry is the concept that as investors take more risk, they should expect more return. In practice this equates to a risk-free rate of return, usually based on the interest rate on Treasuries, plus a premium for risk. In recent years this relationship has gone haywire since the introduction of ultra-low interest rates. In many markets – Europe and now Japan – central banks have set rates at zero or even negative confounding the idea of a risk-free rate. This forces investors to continue taking additional risk to even generate positive return, if they don’t want to have their savings and spending power slowly eroded by inflation.

…central banks have set rates at zero or even negative, as of the first quarter, confounding the idea of a risk-free return.

No one really knows what the outcome of negative interest rates will be in the long run. European banks have largely absorbed the negative float and did not pass through costs to customers, but as rates go further negative, banks are beginning to pass through costs. Economists believe, though, that consumers will flee banks if negative interest rates exceed –.5%, and some have even suggested eliminating hard cold cash in order to force investors to choose in electronic form – pay for no risk, or get paid for taking risk.1 It is a stark but confusing situation for investors.

So where do we go from here? We’ve discussed before the way that low interest rates can increase bond prices particularly, and they also support stock prices. The Fed would like to raise rates, which we support, but is holding them at artificially low levels for fear of triggering a relapse in the global economy. Meanwhile, we retain confidence in the power of equity investing to bring positive real returns over the long term – and so we remain committed to stock allocation in your portfolios despite our continued concerns about unprecedented distortion in monetary policy.

We know our investment decisions come with uncertain outcomes – at least in the short term. Thus we continue to diligently diversify to reduce that near term portfolio risk, even as we seek exposure to growth particularly in equity markets when unexpected opportunities emerge, and we will continue to adjust your portfolios accordingly.

This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.

1. Edwards, Jim “Negative interest rates in Switzerland have started a bizarre debate among economists over whether cash should be abolished,” Business Insider, November 29, 2015.