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The arithmetic of today's minuscule interest rates - what some investors have called "financial repression" - leads to some far-reaching conclusions and unpleasant implications.

In the good old days (i.e., the historical averages since 1926), intermediate US government bonds earned about 2.5% real (i.e., above inflation), while stocks earned about 7% real. Today, the market expects a real return on intermediate Treasurys of roughly negative 0.5% (as derived from the current yield on Treasury Inflation-Protected Securities, aka TIPS).

Assume for the moment that stocks continue to outperform bonds by 4.5% as they have in the past. This implies an expected real return on stocks of only 4%, instead of the 7% that most financial plans blithely assume. It also means that a 60-40 balanced portfolio might only have an expected real return of about 2.5%. This is a rather astounding result: to have the same real return expectation today that a 100% government bond portfolio would have carried in the past, one might have to allocate more than half the portfolio to stocks. And, of course, we're only talking expectations, not guarantees, since actual stock market performance often varies substantially from expectations, even over long holding periods.

The investment implication is clear: central banks' negative real interest rate policy significantly worsens the risk-return tradeoff for everyone. Investors are faced with a lousy choice: take more risk to maintain one's return expectations, or reduce return expectations to maintain one's risk exposure (or some combination of the two).

The retirement planning implications are equally unappealing. If investors take on more risk, they introduce more uncertainty into portfolio performance and, by extension, retirement spending. Conversely, if investors accept lower return expectations, they must also be willing to defer retirement, save more now and/or reduce spending in retirement.

Investors still hoping to retire on schedule will have to become more adventurous in their asset allocation. On the fixed-income side, consider emerging markets local currency bonds. Relatively high yields (near 5%), combined with strong fiscal balance sheets make these an attractive complement to the depressingly low yields available on US investment grade debt. Currency risk is always an issue with emerging markets securities during any worldwide economic slowdown or financial crisis. However, in the long run we expect some currency appreciation from these bonds, reflecting the faster underlying growth rates of emerging markets economies.

Specific ETFs that target this sector are WisdomTree Emerging Markets Local Debt Fund (NYSEARCA:ELD), Market Vectors Emerging Markets Local Currency Bond ETF (NYSEARCA:EMLC) and iShares Emerging Markets Local Currency Bond Fund (NYSEARCA:LEMB). Investors working with financial advisors may also consider the Goldman Sachs Local Emerging Markets Debt Fund (GAMDX, GIMDX).

In the equity arena, REITs are a likely beneficiary of low long-term borrowing costs (the same low interest rates now penalizing savers), even amidst a sluggish recovery. The Vanguard REIT Index Fund (NYSEARCA:VNQ) is a low cost, all-purpose offering in this space.

While these diversification moves may improve both risk and return expectations at the margin, the bottom line implications of financial repression remain: take more risk, save more, and/or defer retirement. We see no pain-free alternatives.

Source: On Financial Repression And Rate Of Return Expectations