September 26, 2016
In mathematics, the square root of -1 is equal to 1i, an imaginary number. In finance and economics, negative interest rates were thought to be imaginary and impossible. In the last few yers, the impossible has become reality.
What Are Negative Interest Rates?
Negative interest rates result result in the investor or buyer of the bond paying interest to the issuer to purchase that bond. For example, assume that the Swiss government’s 3-year bond rate is -1.0%. If an investor bought a Swiss bond at 100% of the face value (par), then the investor would receive approximately 97% of the face value at the end of three years. That represents a face value discount of approximately 3% (1% x three years).
Negative interest rates currently exist in many countries in the developed world, including Denmark, France, Germany, Ireland, Japan, and Switzerland. An article published on August 15, 2016 on ZeroHedge.com1 noted that negative-yielding bonds (both government and corporate) now total $13.4 trillion dollars and are found in countries that account for 25% of global economic activity, as measured by Gross Domestic Product (GDP).
How Is This Possible?
Most traditional economic books have no section on negative interest rates, as none of the well-known economic minds (e.g., Keynes, Hicks, Mankiw, and Friedman) thought it possible to produce negative interest rates. However, frictional transaction costs could allow central banks to charge negative interest rates. For example, there are storage and security costs to hold a large number of $100 U.S. bills, as well as 500 Euro and 500 Swiss franc notes. Estimates have placed these costs at up to 1% annually, which suggests that negative interest rates could decline to that 1% cost level. In addition, if investors expect deflation—that is, increasing purchasing power for future francs—then an investor would be willing to trade 100 Swiss francs today for 97 francs in three years, expecting those 97 francs to buy more in the way of goods and services in the future than 100 francs today. We experienced this deflationary phenomenon in the U.S. during the 1930s, as inflation rates declined and were negative.
How Did We Get Here?
The key motivations for central banks in creating negative interest rates were to support the fragile financial systems of their countries and to spur economic growth. There is an inverse relationship between interest rates and borrowing; theoretically, low rates will encourage borrowing, leading to spending and economic growth. During the Great Recession of 2008/2009, the global financial community suffered a massive meltdown as credit concerns and liquidity problems (think “bank run”) led to a substantial recession with massive banking stresses worldwide. Sweden was the first country to realize negative interest rates, followed by Japan and several European Union (EU) countries. While not negative, U.S. interest rates have been low (at or below 2%) for several years.
Massive quantitative easings are ongoing in the EU countries and Japan, as the central banks continue to purchase government and corporate bonds. As a result, the worldwide monetary system has introduced a huge non-market driven distortion to the investment system with yields near or below zero. The bottom line is that, because of these distortions, many of the financial and investment models break down (see drawbacks described below).
What Are the Goals of the Central Banks?
In their efforts to support the financial system, the central banks resorted to negative interest rates to motivate banks to lend and investors to step out on the risk spectrum to earn “reasonable” returns and yields. Cash holdings were meant to be discouraged. In fact, one of the stated goals of the central banks was to inflate financial assets to spur consumption. If weath in general is increased, people will spend some of that new wealth. For example, if the value of one’s house goes up 50%, then one could borrow against that new equity in the house and maybe do some remodeling or buy a boat.
While not widely acknowledged, another intended outcome was to devalue the country’s currency in order to spur export growth. For example, if the Japanese yen devalues, the U.S. dollar would buy more yens and it would be cheaper for U.S. dealers to import Toyotas than before the devaluation. This spurs additional buying by U.S. dealers and increasing export growth in Japan.
Why Would Anyone Accept a Negative Interest Rate?
That is a good question. For one, as noted above, if an investor believed that deflation was occurring, then even the reduced proceeds at maturity may be desirable. For example, in a deflationary environment, a new car costing 30,000 Swiss francs might be purchased in three years for 24,000 (a 20% price decline). Using the example above, a decline from 100 francs to 97 francs in three years (a 3% decline) would be substantially more valuable relative to the price of that new car. It would take fewer francs to buy that car in three years, despite the decline to 97 francs from the negative rate investment. Secondly, we acknowledge that most people do not want to own bonds with negative rates. This is one of the reasons there has been a scramble to find any positive earning asset, whether it be a corporate bond, preferred stock, or high dividend stock. Those that are buying negatively yielding bonds are either required to purchase them (e.g., European and Japanese banks), or are dealers who buy them for a short term trade, buying at one (negative) price and selling at a higher (more negative) price. Finally, the key factor is that the central banks are buying large amounts of bonds, and are insensitive to the yields, resulting in governmental monetary policies distorting “normal” investment markets.
What Are the Long Term Impacts from Low and Negative Interest Rates?
We see a number of drawbacks. Modern portfolio theory and various investment valuation models rely on an assumption of what a sovereign country’s bond yield is (also known as the “risk free” rate, assuming a minimal chance that the government defaults). With the current near-zero or negative interest rates, many of the financial models fall apart. Is a negative rate a realistic “risk free” rate? These are the unknowns being introduced into finance and economics.
In addition, negative interest rates and a modest 1-2% inflation rate suggest significant negative real rates of return. That is, if inflation is 1.5% and the actual 3-year interest rate is -1%, then the investor is losing 2.5% in real value annually (-1% interest rate and 1.5% inflation combine to a net -2.5% impact). Basically, 100 Swiss francs invested today return 97 francs in three years (see example above), but they are also worth about 5% less at the end of the period. In three years, this investment may be only worth 92 francs in today’s value. That's negative real returns.
Another result is that liquidity traps have become real, as many people look to “put cash under the mattress” in various different ways rather than borrow to invest or to consume. In an article published on April 18, 2016 on Bloomberg,2 Simon Kennedy noted that, “Japanese families seem to have a sudden affinity for home safes. According to the Tokyo-based manufacturer [of safes] Eiko, shipments have doubled since last fall. And in Germany, insurer Munich Re has stashed some 10 million Euros ($11.4 million) worth of its own cash into vaults... ."
Low and negative interest rates are rewarding the borrower rather than the saver/investor. This is making the issuance of debt attractive to borrowers in certain cases. Many corporations have borrowed large amounts of debt to purchase outstanding stock of their company or to purchase other companies. Ultimately, this debt does not underpin assets that foster future growth, such as investing in factories or R&D. Instead, we observe financial engineering in many companies. Mergers and acquisitions are spurred by cheap money. It is natural that a European multi-national company, which can borrow 10-year money at less than 2%, might have an interest in a U.S. or another European company, and, additionally, they might be interested at a higher valuation level than would normally be expected. The low borrowing cost allows the company to invest in a company that may result in a much lower return than would be expected under more “normal” conditions.
In the end, the added economic benefit of low and negative rates in terms of growth may prove minimal or nonexistent. These are uncharted waters. Whatever the outcome, economists will be studying these times and events for decades to come.
How Do We Invest in This Kind of Environment?
We remain flexible and opportunistic in this previously unchartered environment. With real returns near zero or negative, absolute (total) returns may become more relevant. How can we beat an anticipated 2-3% inflation level going forward? Bonds may provide stability at approximately the current inflation level, but any real returns are likely to come from stocks and other assets. A diversified portfolio of stocks, bonds, and cash, along with possibly other alternatives, should provide flexibility and opportunity to buy a portfolio that produces positive real returns. We believe our fundamental investment approach, with bottom-up stock analyses focused on intrinsic values derived from cash flows and earnings, should serve well in the next five to ten years, and will hopefully produce returns in excess of inflation levels.
Given the unknowns of today’s zero-and-negative-rate environment, the old adage of “risk vs. return” becomes even more relevant. The central banks are forcing investors to take on additional risk per degree of return. Our job is to determine whether the risk/return relationship makes sense given the specific situation each of our clients face. Over the past century, Clifford Swan has served clients through all market scenarios, and we continue to manage through the current financial environment.
1 Durden, Tyler. “‘It’s Surreal’—Negative Yielding Debt Rises to Record $13.4 Trillion.” ZeroHedge.com 15 Aug. 2016.
2 Kennedy, Simon. “The Sub-Zero Club: Getting Used to the Upside-Down World Economy,” Bloomberg.com 18 April 2016.
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