Negative Interest Rates — April 2016

 

April 25, 2016

Dow Jones Average: 17,977
S&P 500 Index: 2,088


Negative Interest Rates

After the financial crisis of 2007-2008 the central banks in the developed economies of the world adopted a policy of extremely low interest rates. The strategy was to promote economic growth by making borrowing much cheaper, while offering no safe rate of return to savers. Any return on investment could only come from adopting increasing levels of risk, either in the stock market or low-quality fixed income investments. After seven years of unprecedented central bank control, one would have to say that the outcome for the global economy has been disappointing. Europe and Japan have been slipping in and out of recession, China’s economy has decelerated considerably, and growth in the U.S. has slowed to a crawl in recent months. Now, several major countries are doubling down on a strategy that has had dubious success and are pushing interest rates even lower.

It once appeared that zero percent rates of return would be a natural floor for government bonds, but in recent months rates have gone into negative territory in Japan, Germany, Sweden, and Switzerland. Even Spain recently offered investors a negative rate of return on government debt, only three years removed from a bailout. Negative rates mean that an investor is guaranteed to get less than their original deposit back after a certain period of time has elapsed. A deposit of one hundred thousand dollars drops in value by say five hundred dollars over the course of a year. The old adage that “money makes money” in some sort of automatic fashion is becoming less and less true. It may now cost something to simply store money safely.

Why would anyone in his or her right mind make a deposit that produces a negative return? The answer is that the alternatives might be worse. Consider the plight of investors in Japan. The interest rate on ten-year, Japanese government paper is two tenths of one percent, and on thirty-year paper it is three tenths of one percent. Those are long time periods to lock up capital at virtually no return. With options so limited in their home country, Japanese investors have a strong incentive to search worldwide for yields, but doing so involves currency risk. In recent months that currency risk has been obvious, as the Japanese Yen has jumped in value by ten percent against the U.S. Dollar and other major world currencies, which would have produced a commensurate ten percent, currency loss on any overseas investment.

For an investor in the United States the situation is not so dire, as one can still get a positive rate of return by investing in government bonds. However, the returns are paltry and the situation has encouraged excessive risk-taking within the rest of the bond market. The recent collapse in oil has exposed many investors to large losses in the bonds of speculative energy companies. Up until recently, these high-yielding bonds were a favored investment among more aggressive investors. The other option for any investor is to simply abandon the bond market and invest more fully in stocks. This has been a winning approach since the financial crisis, but one that brings with it significantly more volatility. And the strategy becomes more questionable as markets become more expensive. Equity returns have been flat now for nearly fifteen months, punctuated by periods of sharp declines. Many conservative investors, both abroad and in the U.S., have come to the conclusion that they simply must accept negligible or slightly negative rates of return in an effort to conserve their capital.

Current Strategy

Global stock markets have been highly volatile in 2016 as investors grapple with the implications of falling global interest rates. By lowering rates and continuing a policy of quantitative easing, central bankers in Europe and Asia sent a clear signal that all is not well with the global economy. The U.S. Federal Reserve was hoping to initiate a series of 1/4 point rate increases this year, but has since abandoned those plans, which were out of step with global economic reality. The weakness in many economies, particularly China, gave investors great pause in January and February. Stock markets tumbled around the world by fifteen to twenty percent, before staging a sharp recovery. Once again, investors chose to re-enter the stock market instead of earning no return on cash. Over a longer time frame, stock prices have always fundamentally reflected the underlying economy. The risk for investors is that buoyant stock prices currently reflect the desperation of yield-starved investors, rather than strength in the economy.

We did not alter our equity strategy in response to market volatility in 2016. Most of the accounts we manage have a number of core positions in the medical, consumer, and telecom industries. In our opinion, relatively stable revenue flow and above average dividends make these stocks attractive holdings in an uncertain, global economy. A few growth companies, and some potential recovery candidates in the industrial and agricultural space supplement the core holdings. While we are always hunting for new, reasonably priced stocks, we are not going to let overall exposure to stocks get too large in this high stock market.

There has been quite a bit of activity over the past nine months in the fixed income side of portfolios that we manage. The Federal Reserve’s comments, about a series of potential rate increases in 2016, opened up a brief window of opportunity for bond purchases at higher rates. We started with some longer-term municipal paper in mid-2015 that offered yields of between three and four percent, and then moved to shorter-term corporate and treasury bonds in late 2015 and early 2016. The shorter-term, corporate paper was purchased at yields of between one and three quarters to four percent, depending on the particulars of the bond. The treasuries had yields of about 1/2 percent to one percent, which was actually a multi-year high for treasuries of short maturity. The buying opportunity closed quickly in March 2016, as the Fed put further rate increases on hold.

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