October 1, 2019
In his first speech to the United Nations, President Trump declared that America’s foreign policy would be “guided by outcomes, not ideology.” It was a passionate argument for a return to the dispassion and realpolitik that were hallmarks of U.S. diplomacy in the early 1970s. It was also a message that could just as easily have been directed to investors trying to make sense of today’s markets.
Investing has become the financial equivalent of realpolitik. Although there are a myriad of views on the wisdom of the current central bank policies and the administration’s trade stratagems, what matters most is the world as it exists. Understanding that reality, as it pertains to the economy and interest rates, and pragmatically reacting to it will be key to navigating markets in the years ahead.
The price of money is likely to stay really low for a really long time
Remarkably, the Federal Reserve has embarked on a cycle of cutting interest rates at a time when the economy shows no sign of distress and wages are rising because employment remains robust. Were past prologue, the central bank would not be cutting interest rates, as convention holds it is not needed. Convention being a thing of the past and the burgeoning pile of negatively yielding debt—currently $14 trillion globally—a new paradigm has emerged. It is one that is foreign to investors who have witnessed multiple market cycles. It is a bit akin to calling a real estate company a technology company, as financial promoters of WeWork have done in the run up to the company’s failed IPO.
Interest rate cuts are not unusual when done in the context of an economic slowdown that appears destined to end in recession. It has been more than 30 years since the central bank conducted a “one and done” cut. Indeed, central banking in the 21st century has assumed an expanded and self-appointed mandate to become the “Department of Market Tranquility” rather than an institution charged with ensuring full employment and stable prices (and acting as a financial back stop during extreme periods). If history serves as a guide, when the Fed commences a cutting cycle by reducing the Federal Funds Rate1, usually in response to an economic threat, it ultimately cuts by between 300 to 500 basis points. To date, the central bank has reduced the Fed Funds Rate by 50 basis points with more likely to come.
Despite the 20%-plus gains in U.S. stocks year to date and, more importantly, the herculean efforts of capital and policy, the domestic economy has failed to achieve escape velocity from a low interest rate environment. It appears that the American interest rate orbit is starting to look more European or Japanese than that which one would associate with the world’s most dynamic and vibrant economy. To be sure, the short-term effect of falling rates has led to double-digit gains for long-term government and corporate bonds this year. But make no mistake: Interest rates are likely to be stuck in low orbit for some time to come—or worse.
Negative rates are a real possibility in the U.S.
The phenomenon of negative interest rates seemed like a Japanese problem, until it spread to Switzerland, and then to other parts of Western Europe, and then to Eastern Europe.
After the Federal Open Market Committee cut interest rates by a quarter of a point in September, Fed Chairman Powell downplayed the likelihood of negative rates taking hold in the U.S. “I do not think we’d be looking at using negative rates,” he told reporters. “I just don’t think those will be at the top of our list.” Top of list, no, but this leaves open the idea that it is considered a possibility.
The President, as if on cue, quickly offered a different point of view, tweeting that “The Federal Reserve should get our interest rates down to ZERO, or less.”
Whether Powell heeds the President’s advice or not, the fact remains that in the past five rate cycles the Fed has lowered short-term rates on average 375 basis points to support the economy. Following the September cut, the Federal Funds rate stands between 1.75% and 2% which means a follow through of a near-average easing cycle would place rates at or below zero.
All things considered, there’s a 50% chance that negative rates will eventually find their way to our shores. Indeed, the groundwork is already being laid. Longer-dated bonds are already sporting negative yields on an inflation-adjusted basis. Some central bankers are suggesting negative interest rates are not a big deal and none are saying they are out of consideration.
The economy is fine…for now
Lost in all the talk about negative rates and slowing global growth is the fact that the U.S. economy continues to trundle along. The OECD projects 2020 U.S. GDP growth near 2.3% and for Euro Area near 1.4%. The Philadelphia Fed projects U.S. GDP growth to continue around 2% into 2021 and 2022. Our base case remains that a U.S. recession is not something we will have to contend with this year or next.
Part of this confidence is rooted in the power and importance of the consumer. With roughly 70% of the American economy related to consumption, the only way the economy would slip into recession is if consumers pulled back. This could occur either outright through a cascade of uncertainty, most likely brought on by job losses, or through concerns about their economic future. With unemployment near 50-year lows, consumer confidence near record highs, and retail sales continuing to rise, it is hard to see how a consumer-led recession is close at hand.
Low interest rates and low growth: a constant companion
Contrary to the received wisdom of the day, low interest rates do not promote faster economic growth. Instead it is an exquisite way to ensure that the dead hand of debt remains draped over the commercial landscape. The failure of market-determined interest rates to inform capital allocation results in mistakes with investment, stifles capital formation and, therefore, reduces new productive commercial investment. It also perpetuates the survival of companies that fail to earn their cost of capital from slipping into oblivion, thereby hindering better-run companies’ access to capital.
Independent research shop Gavekal advanced this notion years ago and recently reiterated it in an excellent book, Clash of Empires: Currencies and Power in a Multipolar World. As Exhibit D reveals, periods of negative real interest rates correspond with durably lower levels of economic growth than those with a positive, inflation-adjusted price of money.
The failure of the economy to sustain escape velocity from low interest rates suggests that low growth will be an enduring feature that investors and policymakers will have to navigate in the years ahead. They’re already being confronted by slowing corporate earnings growth, with S&P 500 profits expected to grow just 1.5% this year.
Conversations with others in the business of managing capital all have a common feature: wonderment at the persistent meddling of policymakers in markets, either through distortions in the price of money or tearing at the commercial order that has served society fairly well since the end of the second World War. This enduring state of play will likely significantly limit the United States’ long-term growth prospects. Indeed, it consigns the country to an enduring muddling along that has been an anathema to workers and rentiers alike.
Real Investissement: The paradox of protecting capital in a negative interest rate environment
The return of falling interest rates and negative real return on cash essentially strips away choice for investors. No longer can cash be a place to shelter in periods of prolonged uncertainty. Like a force of nature, cash seeks a rate of return. Like water, it flows to wherever it perceives an opportunity for return. Consequently, the first beneficiary of cash in motion is the equity market. The acronym TINA (There Is No Alternative to equities) has once again been resurrected in the language of investors. Yields on fixed income securities have also begun to plumb new lows as prices are bid higher.
We have remained resolute in the belief that interest rates did not need to be cut as they had at last achieved a semblance of normalcy without damaging growth in the real economy. Indeed, the growth concerns of late had their roots in the grinding, multi-front trade conflict. Policy uncertainty and chaos is the antidote to commercial confidence, which is a precious asset in a long-lived economic cycle.
Dealing with the world as it is rather than how we think it should be is the more profitable route. When interest rates actually yielded something more than the rate of inflation, holding cash in portfolios was a prudent buffer against late-cycle market ructions. In light of the environment now unfolding, clients should reconsider their cash positions. In other words, maintaining only the cash needed to fund near-term expenses and to weather the emotional stress a market correction inflicts. To be clear, this is not a call to add risk to a portfolio; rather, it is an acknowledgement that the very asset one looks to for stability is the asset that guarantees a loss (of purchasing power). Adding insult to injury, as the value of cash falls, other asset prices tend to rise. When reducing cash in a portfolio, we favor more defensive equities, shares with less volatility associated with their prices than the overall market, and those companies that enjoy a relatively higher dividend yield.
Elsewhere, as falling interest rates lower borrowing costs, income-producing real estate will begin to generate interest. As real estate asset values benefit from falling financing costs, we are also exploring opportunities that will likely emerge in segments of the mortgage markets wherein investors can enjoy a modicum of yield whilst not assuming much interest rate risk.
From a larger perspective, investors should consider focusing most of their equity capital on the developed economies rather than the emerging markets as the dollar is likely to remain stubbornly strong even as yields fall. When it comes to currencies, everything is relative.
In the years after the Great Financial Crisis, the concept of “New Normal” was coined to describe the environment of low growth and low interest rates. There was a school of thought which revolved around this descriptor that informed both investors and policymakers alike. I cannot help but wonder whether the emergent philosophy for the investor class in the waning months of this decade should be Real Investissement—a world in which there are no grand philosophies or theories of markets and economies and there are no permanent allocations or strategies, only changing interests.
1 The interest rate which depository institutions lend to one another reserve balances held at the Federal Reserve
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.