The challenge of lower rates
Government officials, making more moves this week, are guaranteed to cause some further head scratching. First, the European Central Bank started yet another wave of monetary easing yesterday; and next week, the Fed is likely to cut interest rates by another quarter point. Meanwhile, President Trump just tweeted: “The Federal Reserve should get our interest rates down to zero, or less …”
Already, today’s fixed income markets are littered with massive amounts of bonds paying nothing and less than nothing. According to a recent study by Deutsche Bank, over $15 trillion of government bonds worldwide now trade at negative yields.
With very few exceptions government leaders and the so-called experts employed by central banks around the world believe free money will grease the wheels of economic progress. Amazingly, this paradigm exists despite over a decade of zero interest rate policy which has only resulted in slow growth and low inflation.
Nevertheless, prior experiences of widely accepted but misguided theories demonstrate that senseless paradigms can exist for very long periods. In his timeless book, Extraordinary Popular Delusions and the Madness of Crowds, celebrated author Charles Mackay documents how easily and often the general public has been swayed during past eras that most of us would now rather forget.
While high and rising interest rates can be a headwind for the financial markets as we saw last year, an extended period of ultra-low rates may likely to do just as much damage.
To begin with, lower rates punish savers. Older folks or those approaching retirement are now caught on the horns of a dilemma. These individuals must either try to save more or assume a higher level of risk to hopefully improve their retirement situation. Of course, higher savings by a large swath of the population means less spending — typically resulting in lower overall consumption and economic growth.
Furthermore, the entire banking system is leveraged to interest rates. In a normal environment, banks make loans to creditworthy borrowers in order to generate profits. However, with negative interest persisting throughout Europe, banks must actually pay to hold loans and securities. In other words, financial institutions are being punished for providing the credit essential to economic growth. German economic data has recently veered south as Europe’s largest economy approaches recession.
The damage to bank profitability is evident in today’s share prices. Over the past year, the US-based KBW Bank Stock Index is down 8 per cent while the S&P 500 has advanced 5.63 per cent as of this writing due to America’s inverted yield curve which has damaged profit margins. In Europe, where negative rates are the norm, the European bank stock (Euro STOXX Banks Price) index is trading near a 30-year low.
Just as individual investors must plan for retirement, pension funds worldwide are in crisis. Most defined benefit pension plans assume a reasonable rate of return on investments designed to meet future liabilities as fixed payouts are promised to beneficiaries.
But zero and negative interest rates have turned these assumptions upside down and have led to staggering amounts of unfunded pension liabilities. Corporations must add cash from profits to fund pension plans or begin to reduce payouts to beneficiaries. Either outcome results in less distributable income to the general public and ultimately lower economic growth.
The presently popular theory that negative interest rates are somehow good is likely influenced by forces outside America. Specifically, unfunded social programmes and wayward budgets existing in Europe and Japan have begun to wash up upon American shores just as protectionist policies regarding trade and immigration policies have already slowed growth.
Mark Grant, chief global strategist of FB Riley recently opined that “the nations of the European Union, Switzerland and Japan can no longer afford their budgets, or their social programmes, or various EU expenditures without raising taxes and causing upheaval in many governments and in the European Union, itself. This means that the nations in the EU, are basically insolvent, and are only hanging on by the use of the ‘Manufactured Money’ from their central bank.”
In psychological terms, we would call this process “enabling”. However, it is pointless to fight the trend. Responsible government leaders are simply unelectable by the general population who are essentially unaware their savings have been sacrificed. Therefore, investors must brace for lower interest rates and greater market volatility.
As Mr Grant points out, “borrowers are standing in Heaven and investors are standing in Hell”. I cannot disagree with this opinion except with the caveat that heightened market volatility may be beneficial for opportunistic and well-positioned investors.
Even in the world of declining interest rates, opportunities often arise for those plugged into these fast-moving markets. For example, US pipeline companies have been left behind in the grab for income-producing assets and still offer some of the best current yields on the planet. These securities are largely backed by relatively stable earnings and cash flows.
Also, lower rates allow more headroom for equities to move up as stocks become the only viable alternative to disappearing bond yields. Indeed, large-cap growth stocks which have so far led this bull market, should continue to perform well as innovation appears the best pathway to offsetting the increasingly heavy hand of government and central bank policies.
In fixed income, investors should consider a “barbell” strategy which takes advantage of the inverted yield curve while also protecting against a further drop in rates.
In equities, investors may also consider a barbell structure which balance allocations between growth, value, small-cap and large-cap positions. While innovative large-cap growth companies continue to exhibit positive trends, small-cap and value stocks have dramatically underperformed in recent months and could be due for a near-term bounce.
Bryan Dooley, CFA is the senior portfolio manager and general manager of LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority
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