For a long time now we’ve argued the normalisation of interest rates around the world from the unprecedented post-GFC monetary policy experiment is something that investors need to watch carefully. We do not subscribe to the argument that the rise in share markets is due to central banks ‘printing money’ via QE – that’s a classic case of correlation is not causation. However, we do believe that low interest rates, made possible by low inflation, have underwritten higher PE (price to earnings) ratios on shares. That is, with such low returns available elsewhere investors are willing to pay a higher price today for a company’s future earnings. So the level of interest rates is very important. In this article Tim Farrelly, principal of our asset allocation consultant farrelly’s (yes, with a lower case F!), puts a typically logical and elegantly simple case for why interest rates could stay very low for a long time to come.
Extract from farrelly’s Dynamic Asset Allocation Handbook December 2014
Just how hard it will be to raise interest rates is starting to become very apparent. Japan has been stuck at close to zero interest rates since 1993; Europe seems to be toppling towards deflation from which it may find it hard to escape; in the United States, mere talk of an early tightening from the Fed sent the US dollar sharply higher and has killed any possibility of an early rise in the Fed funds rate. In Australia, five years into the recovery, the economy is still struggling, despite historically very low interest rates. With the market now thinking that the next move in interest rates is more likely to be down than up, the much anticipated return to normal interest rates seems a long way off in Australia as well. Even New Zealand, with its buoyant economic growth, seems to have come to the end of its tightening phase with the Official Cash Rate sitting at a lofty 3.5%.
While it is one thing to suggest that central banks may struggle to lift interest rates over the next 12 to 18 months, it is quite another to suggest that, as a result, rates are going to still be low for five or even 10 years or more. However, historical evidence suggests that this is a real possibility. In a paper released in April 2012, Ken Rogoff and Carmen Reinhart looked at the behaviour of interest rates during past deleveraging cycles. They examined a number of different events with the key ones being the deleveraging processes following the panics of 1870, 1929 and 1990 in Japan. Their key findings were that, in these periods, interest rates tend stay very low for a very long time – in fact, 23 years on average.
In 2024 – 10 years from now – some 17 years will have past since the start of the Global Financial Crisis. We expect that interest rates around the world will have normalised, even if it is to a new, lower normal. Nonetheless, we do accept the very real possibility that this may not be the case, that interest rates around the world may still be close to zero. Either way, it is looking more and more as if low rates will be with us for a long while yet, if not necessarily for another 10 years.
Won’t governments try to inflate away the debt?
As commentator after commentator have remarked over recent years, governments have historically relied on inflation to reduce the size of debt as a percentage of GDP. In fact, the way that real debt reduction is achieved is by keeping real interest rates low or better still, negative. Inflation at 8% and interest rates at 10% makes borrowers 2% a year worse off. Interest rates of zero and inflation rates of 2% makes governments 2% a year better off. It’s not the level of inflation that matters, it’s the level of inflation compared to interest rates. Or, more accurately, it is GDP growth rates compared to interest rates that is the key.
The dilemma facing governments is how to keep economic growth rates up and interestrates low. Inflation tends to be bad for growth and, in an era of somewhat independent central banks, is also very bad for real interest rates. The last thing a government wanting to reduce its debt needs is inflation. Instead, governments that want to reduce debt and be re-elected should be – and generally are – hell bent on keeping growth positive, inflation low and real interest rates negative. From a macro economic view, the best way for an overly indebted government to check inflation in the event of a runaway economy caused by too low interest rates is fiscal restraint. It is slow but effective and has the benefit of reducing both the deficit and debt.
Next time you hear about governments wanting to inflate away debt, you have two choices. Tune out, or rush out and buy gold. farrelly’s strongly recommends the former.
What of deflation?
This is an interesting question. From the point of view of reducing debt, deflation is clearly undesirable. Over-indebted governments are much better off with 2% inflation and zero interest rates than 2% deflation and zero or marginally lower interest rates. It is bad news.
Beyond that, farrelly’s has long been of the view that concerns about deflation are vastly over done by economists worried about a re-run of the Great Depression. Fighting the last battle has never been a brilliant strategy.
Here is farrelly’s read on the impact of deflation.
- Deflation is predominantly a symptom rather than cause of economic malaise. When an economy is depressed to the extent where demand is insufficient, prices will fall. The problem is insufficient demand – falling prices are just the symptom. Nonetheless, shrinking economies are really bad news for those with too much debt. But, again, the cause is lack of demand, not falling prices.
- Falling prices do not cause a fall in demand. In the 1930s, they may have done so. That was in an age where credit was scarce – credit cards didn’t exist – and thrift was seen as a virtue. Culturally, the Western world has moved a very long way from that point. Instant gratification is the dominant ethos. Falling prices in electronics, automobiles, clothing and white goods have been with us for years without causing any noticeable decline in demand. And, it is not just about consumers. Will corporates defer projects if they think they will cost 1% less in a year? We doubt it. They defer projects because of concerns about lack of opportunity. If investment was deferred due to lower investment costs, no business would have bought a computer or a truck for the past thirty years. This one is a complete furphy.
- Deflation is, however, tough for employers and therefore for employment. In a period where inflation is running at 2% to 4% per annum, no pay rise is a big pay cut. This makes adjustment of employment costs much easier than in an environment where prices are falling and where no pay rise is a big increase. In a downturn, employers just don’t need adjustments to be even harder than usual. The end result tends to be lower profits and somewhat lower employment. This is clearly bad.
- Finally, while deflation is bad for government debt, it is not catastrophic. The impact on the size of the debt of 2% deflation and zero interest rates is no worse the impact of 2% inflation and 4% interest rates.
As an aside, the cure for deflation is to forget about prices and solve the real issue – insufficient demand. In an environment where confidence is lacking, substantial and worthwhile infrastructure spending is usually the answer. While interest rates are low or zero, why not borrow long term and get worthwhile projects done? Sell the projects off later if need be. Politicians understand this, but seem to be too timid to act.
What would it take for rates to normalise?
If we accept that low real rates and solid growth remain the goals of deleveraging governments around the world, just what will it take to get rates higher? Unsurprisingly, the answer appears to be the obvious one – core inflation breaking above central bank target ranges which tend to be in the 2% to 3% per annum range. What will get us there will differ from country to country.
The United States
The key will be employment costs because, in the absence of persistent inflation, there is no need for the US to normalise rates. Persistent inflation is driven by rising wages rather than one-off spikes due to food prices, oil prices or currency adjustments. Currently, wages are doggedly sticking in a narrow growth band of 1% to 2.5% per annum. If wage growth got to 3.5% or 4.0% per annum, we could see a quick response by the Fed. Janet Yellen has consistently said that there is no timetable on interest rate increases and that any move will be data dependent. And, it is very clear that the members of the Fed themselves have NO idea whatsoever as to where rates will be. The dot charts released by the Fed outlining its members’ expectations of future interest rates show an incredible dispersion of views. One member believes rates will be at 3% by the end of 2015, four expect rates to be between 1.5% and 2.0%, a further eight expect rates to be between 0.75% and 1.5%, and three expect rates to be below 0.5%. They genuinely have no idea. Nonetheless, with more than half of the members expecting – or hoping – that rates will be above 1.5% by the end of next year, we know there will be pressure from within the Fed to respond to any sign of emerging inflation. And, even if they had no intention of going further, many members of the Fed would be delighted to wake up one morning and find that rates had magically risen to 0.75% and no one had noticed. At least at 0.75% per annum they have the option of cutting should the US economy start to turn down. Today, they have almost no tools other than jawboning.
As a result, farrelly’s seriously doubts that the first rate increases will mark the end of the low interest rate environment in the US. It is more likely that rate increases will be marked by considerable market volatility, more strength in the US dollar, a slow-down in growth and an early halt to the rising rate cycle. This may be good news for bonds. Rising shortterm rates don’t necessarily imply rising bond rates.
Europe and Japan
Forget about rate rises in Europe and Japan. These economies are characterised by low growth, large government debt and a strong desire to keep their currencies low. Increasing interest rates would be counterproductive on all three fronts. We could see some rate rises in the European periphery if default fears resurface. But as long as Draghi is willing to do “whatever it takes” this looks pretty unlikely.
Australia and New Zealand
With the rest of the developed world mired in low interest rates, any sharp increase in rates in Australia or NZ will just push up the value of the currency and stymie growth. This is less of an issue for New Zealand as the Christchurch rebuild is likely to stimulate demand for a number of years yet (the power of productive infrastructure spend) but, nonetheless, rates are still likely to be lower than they would normally sit.
We would not be surprised to see cash rates in both countries at around 3% per annum in five years and 4.0% per annum in ten years. While it may sound dramatic, it’s exactly what the bond market is indicating.
What does it all mean for investors?
It has two main impacts for investors: potentially higher PE ratios; and, lower returns available on secure assets over the long term.
PE ratios – are our forecasts too low?
Perhaps, but not by much. farrelly’s PE ratio estimates are based on an assumption that, by 2024, interest rates will have (new) normalised, Rogoff and Reinhart notwithstanding. farrelly’s estimates cash rates of 4% per annum in Australia and NZ, 3% per annum in the US and Europe and 1% per annum in Japan. These rates would be supportive of PEs of 15.5, 17.5 and 20, respectively. If rates were lower by 1% across the board, PEs of 17.5 for Australia, 19.5 for the US and 22 for Japan would be sustainable. However, these would add only about 1% per annum to returns, so are not critical assumptions.