Getting ready for the brave new world of higher rates

Gentle and gradual the pace of rate hikes may be, but the long period of easy money — by some accounts the lowest interest rates in 5,000 years — has lulled both stock and bond investors into positions and assumptions that will soon prove dangerous.

Investors in riskier assets can expect more volatility and lower returns.

Investors in safe assets like government bonds can expect even worse, as the bond math turns vicious on securities with very low yields.

The central question for investors is always: "How much risk is it sensible to take to get a given amount of incremental return?" That concept is called the efficient frontier.

Over the last five years the clever play has been to load up with risk, usually by holding more volatile investments such as equities. Not only have equity returns been high, they've been particularly high when compared to the amount of volatility investors have suffered. Correlations between assets also have been relatively low, rewarding diversification.

Those good times may now be at an end.

"What is notable for 2016 is that, unlike past years, both our long- and short-term forecasts point to muted equity upside," Andrew Sheets, chief cross-asset strategist at Morgan Stanley wrote in a note to clients.

"Expected equity returns may look low vs. history, but government bonds look even worse and cash has never offered less."

Morgan Stanley sees U.S. equity returns next year at 6 percent, and a 5 percent average over the next decade, both figures in the bottom half of the typical distribution. U.S. government bonds will do far worse: a loss of 0.6 percent next year and just 2.7 percent gains annually over the coming 10.

Very low interest rates have had at least two major impacts on financial markets. The first is to raise the value of all securities, particularly those with more risk or higher yields. The second, and this may end next year, was to suppress volatility. Investors hate volatility, which can force you to sell at the worst possible moment, and will pay more for a given stock or bond when it is low.

On Morgan Stanley's reckoning the efficient frontier sweet spot from 2010-2015 got you a 5.8 percent annual return with 3.1 percent volatility on a portfolio of stocks, 10-year Treasuries, investment-grade credit and high-yield bonds. That's much easier going than was the case from 1990-2009, when you could earn 5.3 percent annually but with 4.3 percent volatility.

Morgan Stanley sees just a 2.2 percent return with 3.5 percent volatility in coming years, not a happy portfolio.

Those numbers may actually look good to the large number of investors and pension funds who, stung by the great financial crisis, loaded up on government bonds.

"As 10-year Treasuries fell to 1.6 percent in 2008 and stocks got liquidated in the financial crisis, two five-standard-deviation events conspired to elevate bond investments in popularity and thrust bond portfolio managers into godlike status," William Smead of Smead Capital Management in Seattle wrote to clients.

The ride down in interest rates hasn't necessarily been that painful for those with heavy bond allocations, but it won't take much of a rise in rates for the pain to become intense.

Andrew Haldane of the Bank of England, citing a long list of sources, in July asserted that rates are now as low as they have been since at least 3000 B.C.

"We think a good rule of thumb is to avoid portfolio success stories created by five-standard-deviation events. They only happen 2.5 percent of the time," Smead wrote.

There are strategies that one can adopt to mitigate the difficulties implied by higher rates beyond just owning fewer government bonds.

Morgan Stanley likes credit as an asset class, at least next year, expecting 2 to 4 percent loss-adjusted returns. Not great, but beats losing money in Treasuries or suffering volatility in equities.

Smead, for his part, posits that if rates go back to their traditional 3 to 6 percent range then it will likely be as a result of economic growth which could benefit sectors like consumer goods, or help financials which would dearly like to see a steeper yield curve.

However it plays out, 2016 won't be much like the past five years, and will very likely be a good bit more difficult for investors.

James Saft is a Reuters columnist.