CIO Letter: A New Regime of Rates Ushers in New Opportunities

After a decade of “easy money,” zero rates may feel like a baseline, but historical data tells a different story. Markets have a long history of distinct real yield regimes. Understanding how we got here can put recent volatility in perspective and help inform where we are headed (Exhibit 1).

1990s: Inflation fears and the beginning of globalization. The U.S. 10-year real rate averaged roughly 3.5%, with the Federal Reserve maintaining the fed funds range of 3.0–6.5%. This period was marked by concerns that included a growing U.S. deficit, fears of decreasing U.S. competitiveness on the global stage and residual apprehensions about inflation still left over from the 70s and 80s.

Early 2000s: The rise of globalization and emerging markets. In the early 2000s, as the dotcom bubble burst, there was a noticeable drop in real rates to an average of 2%, while the Fed moved rates from 1.0% in 2004 to 5.5% in 2006. Key driving forces during this period included globalization the widespread embrace of technology, and the disinflationary effects caused by the growth of emerging market economies. The integration of emerging markets into the world economy introduced a vast and relatively low-cost labor force into global supply chains. As multinational corporations shifted production to emerging markets to take advantage of these cost savings, it put downward pressure on wages elsewhere, especially in more developed economies. The tail end of this era kicked off the move to zero rates, as the excessive leverage that fueled the U.S. housing boom and collapse culminated in the 2007–08 financial crisis.

Post 2008 crisis: Lower for longer ushers in decade of zero rates. After the financial crisis, the world experienced almost a decade of zero to negative real rates. One of the main takeaways from this phase is that a consistent zero rate isn’t historically the norm. The real average interest rate over extended periods paints a more fluctuating picture.

Now, we’re on a journey away from an abnormal regime of prolonged, aggressively stimulative fiscal and monetary policies. We no longer need the emergency measures of the global financial crisis or to help the economy through Covid. While this journey has introduced significant volatility in bonds markets, we believe the current destination is a healthier investment environment than any we’ve experienced since pre-2000: positive real yields, reasonable price-to-earnings ratios, less dependence on fiscal and monetary policy, and less reliance on emerging market growth. Plus, for the first time in 15 years, fixed income is a competitive asset class again. It’s also worth noting that stocks and bonds did well together in periods of previous higher rate regimes.

So—reiterating our message from April—fear the volatility, but don’t fear the destination.

The short answer is yes, we believe real rates can sustain current levels. The Fed will likely be hesitant to cut rates until either inflation reaches its 2% benchmark or there’s a significant dip in employment.

Despite recent challenges and volatility, the bond market offers attractive yields, especially when compared to the zero-interest rate environment during the pandemic. The good news for investors is that you don’t have to reach down in credit quality to generate attractive yield. Investment-grade corporate bonds are delivering yields above 6%.

The increase in corporate bond yields has also drawn attention from equity markets. Exhibit 2 is another illustration that the most recent decade of ultra-low rates was a deviation from the norm. Following the 2008 crisis, corporate bond yields (orange line) stayed well below the earnings yield on the S&P 500 (blue line). This dispersion was largely due to the dip in real yields, which is represented by the brown line at the bottom of Exhibit 2. Corporate yields are now higher than the S&P 500’s earnings yield, reestablishing a level that is more in line with its history. Higher corporate yields should attract more investors to the asset class, helping bring additional stability to the bond market.

Of course, one of the main reasons why real yields have persisted at higher levels is the tight labor market. In the short term, we expect the shortage in labor markets to continue to support wages. However, the corporate response to this labor shortage is going to be more investment in artificial intelligence, robotics and automation spanning every industry—including asset management.

The financial world’s enthusiastic embrace of AI has been one of 2023’s biggest stories. But a lot of the industry talk so far has been “aspirational,” so it’s nice to have something tangible to present.

This summer, the team behind Voya Machine Intelligence (VMI)—which has been pioneering AI-driven investing for over a decade—celebrated a key milestone for its flagship strategy. In the three years since inception in 2020, the Opportunistic U.S. Equity Strategy beat the S&P 500 by 9.4% annually (8.6% net), putting it in the top 2% of its peers.¹ What’s all the more impressive is that it did so despite (ironically) being underexposed to the AI trade in 2023.

While it is still early days for AI adoption in asset management, we believe the potential opportunity for investors is enormous. For example, our machine-driven portfolios often move away from crowded trades due to their unique investment process, providing diversifying return streams in a world of highly concentrated benchmarks. We’ll have a lot more to say around this exciting field as our equity platform continues to enhance the value we offer our clients.