Thought the Federal Reserve's rate hike on Dec. 16, 2015, marked the end of easy money? Think again. Now it's everyone else's turn. Welcome to the Bizarro World of negative interest rate policy (NIRP).
The concept of depositors paying banks for the privilege of holding their money is so new that no one really knows what the unintended consequences might be. The Bank of Japan (BoJ) became the latest central bank to cut its benchmark interest rate below zero on Jan. 29, and already it has had the strange effect of causing a rally in the yen and reducing consumer demand — the exact opposite of what the BoJ had hoped for.
If negative rates become a thing — and the Fed has recently asked big banks to make assumptions about NIRP in their stress tests — the results could seriously distort risk taking. Here's our take on how such a policy could affect stocks and bonds, and the best way to protect client portfolios from the potential impact.
The Buyback Conundrum
Suppose you are the CEO of a publicly traded company in the post credit-crisis U.S. Like many executives, you are struggling to grow a business in the face of an economy that is only slowly recovering. And it's not just an illusion. Since the recession in 2008, our economy has been grinding for seven years and has yet to hit pre-recession GDP growth levels — although the average recovery after a recession is less than 12 months.
Struggling with ways to increase enterprise value, and with few opportunities to grow earnings, many executives have simply purchased their own stock. Buybacks can make sense if one's stock is severely undervalued. It can also be a logical alternative to growing earnings per share when earnings are hard to come by.
But here's the rub: Although buybacks result in higher share prices, which can be a boon for executives who get compensated with stock options, there is little economic effect. This at least explains the disconnect between the equity markets, which are less than 10% away from all-time highs, and the economy, which is sputtering along at a measly 1.5% annualized rate. It has also sparked debates on executive pay and the growing gap between the rich and middle class. According to Thomas Piketty's “Capital in the 21st Century,” two-thirds of the increase in U.S. income inequality over the last 40 years can be explained by the steep rise in executive pay.
The logic of stock buybacks hasn't been lost on many CEOs. According to a 2014 Harvard Business Review study, S&P 500 companies spent 54% of their profits in the last decade (from 2003 through 2012) buying back their own stock. Another 37% of earnings have been used to pay dividends during the same period. That doesn't leave a lot of cash for creating new products or expanding market share.
Buybacks have gotten so prevalent that even shareholders — the folks that stand to benefit from this corporate largesse — are worried. “It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies,” Laurence Fink, the chairman and CEO of BlackRock, the world's largest asset manager, wrote in March 2014. “Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.”
That concern is shared by Jeremy Grantham, co-founder and chief investment strategist at GMO. Speaking to advisors at Morningstar's investment conference last year, Grantham railed against low interest rates, stock buybacks and executives growing wealthy from their stock options, which he said “create a steady stream of bull markets that end badly.”
NIRP and stock buybacks go hand in hand. Faced with a slowly expanding economy, U.S. companies are likely to increase the practice, which can be financed with cheap bonds. It may result in higher stock prices, but the strategy has little or no effect on the original intent of NIRP — encouraging lending that would improve the economy.
There is a philosophical element to this conversation as well. If a corporate CEO states that his firm no longer has growth opportunities and therefore returns capital to its investors in the form of a dividend or a share buyback, is that acting in the best interest of the shareholder? There is considerable debate on whether this short-term thinking is in shareholders’ best interest. Nonetheless, the practice has resulted in a massive redistribution of wealth between corporate executives and the working class.
Unless there is some redefinition of the 1982 Securities and Exchange Rule 10b-18, which gave companies a “safe harbor” from market manipulation if buybacks adhere to a handful of limitations, I expect the practice to continue. The SEC has admitted that it has no ability to enforce the main rule intended to prevent market manipulation when companies buy back their own stocks, and has no intention to monitor the process.
So what's the endgame? There is a limit to how much of its own stock a company can buy; at that point, its mandate changes to increasing top-line growth. Assuming the economy is stagnant, the result is a “reset” — a downward adjustment to stock valuations when investors finally concede that growth opportunities cannot support current market multiples. In a best-case scenario, we’ll muddle through, but returns on risk assets would reflect the assumption of very low inflation.
Back in the good old days, the interest rate on a bond was inversely related to the bond's credit quality. As a result, ultra-conservative U.S. Treasury notes should have a lower yield than a country with less stellar fundamentals.
But that's so pre-2015. Japan, the most indebted G-7 nation with a stunning 230% debt-to-GDP ratio, recently had a successful auction of 10-year debt with a negative rate. The auction had more demand than the previous one, which featured bonds with a positive yield.
Buying a bond with a negative yield is completely rational if the buyer assumes rates are going even lower in the future. After all, that would result in price appreciation. There is another, more onerous reason why investors would pay money to park their capital: the belief that uncertain economic conditions often result in less spending.
Central bankers have largely ignored the psychological effects of negative rates. In Japan, where one in three citizens lives on retirement income, the move to negative rates resulted in confusion. A similar reaction occurred when Swiss rates went negative. While the confusion has since cleared up, Swiss banks have been forced to pass along the burden with a combination of fees and higher mortgage rates, and a similar adjustment may be necessary in Japan.
The effect of negative rates on another large group of bond buyers — pension funds — has been well documented. Last May, the Organization for Economic Cooperation and Development, the Paris-based think tank, said that extremely low rates threaten the solvency of pension schemes, since it forces them to buy lower-quality bonds in an effort to match assets and liabilities. Now that low or negative rates are expected to persist, long-term bonds and similar duration assets don't offer the ability to pay claims in the future (see Figure 1, below).
Insurance companies will likely find themselves in the same boat. If asset returns are negative, insurers need more money today to fulfill tomorrow's liabilities. And if those liabilities are marked to market, the extra costs to meet them will result in a drop in capital levels.
Not every part of the world is facing a negative rate scenario. Let's not forget that the U.S. raised rates by 25 basis points on Dec. 16, 2015. Higher rates are usually associated with battling inflation and slowing down an economy, but that may not be the case in the Bizarro World of NIRP.
How can higher rates stimulate demand? First off, rate hikes signal that a central bank is bullish on its home economy. That signal could be transmitted to consumers, spurring them to spend more money. Higher rates would encourage more lending, especially to small businesses.
This is one group that has found access to funds especially problematic. According to the Bureau of Labor Statistics, firms with fewer than 50 employees account for the same net job growth as firms with 500 or more employees, so easier access to capital could result in a big boost in employment. Increased yields on CDs and other time deposits would be a welcome change for many older investors who cannot bear the risk of the capital markets.
Finally, higher rates would signal an end to the Fed's backstop of the stock market. This would diminish many unintended consequences of QE, including the increased possibility of asset bubbles and distortion of capital markets brought about by investment decisions that in normal conditions would never be made.
There are some adverse effects to higher U.S. rates. It might cause a huge spike in the dollar, which would hurt domestic companies doing business overseas. The benefits outweigh the risks, in my opinion, although much lower rates in other parts of the world will likely slow the Fed's higher rate strategy.
Even in a negative rate environment, there are opportunities for advisors to add value to client accounts. First off, I’d like to highlight some opportunities in the fixed income sector.
I’m not a fan of buying bonds with a negative yield, even if one believes that rates are going even more negative. Such a position is known as a “negative carry” trade — in other words, one where an investor pays to own the bond. Even if rates do go lower, the capital gain must exceed the negative rate to create a profit. It's a unique strategy, and one in which an investor could be right about the direction of the market and still lose money.
Fortunately, there are less esoteric options. The extreme volatility of the stock market this year has made nearly all investors skittish, including bond buyers. That has resulted in an abnormally wide credit spread.
One of the most useful of economic indicators is the credit spread, which measures the difference in lending rates between corporate and government borrowers. A relatively narrow spread shows that investors see little difference in risk between these two types of borrowers, while a widening spread means that corporate credit is seen as a less certain alternative to rock-solid U.S. Treasuries.
As one would expect, during periods of economic uncertainty credit spreads tend to increase. Indeed, after years of near record-low spreads, the difference in yield between high-yield bonds and Treasuries of the same maturity have risen to levels not seen since the credit crisis, although spreads have yet to blow out to the extreme levels seen in 2008.
They are, however, wide enough to be attractive in the current low-rate environment (see Figure 2, below). Good quality corporate bonds can be had with a yield close to 4%, an attractive rate considering the virtual absence of inflation. One area of opportunity is low-duration notes from the largest banks. That group was downgraded last December by Standard and Poor's (a move caused by views that the likelihood of a government bailout in the future is uncertain), thus boosting their yields.
Junk bonds have also seen some yield expansion. As Figure 2 shows, the extra yield required by investors to hold junk bonds has increased to around 700 basis points. The recent recovery of the asset class has caused some high-yield players to return to the fold. Convertible bonds are also interesting, as the combination of yield and upside potential from the equity market make them a cogent alternative to straight equity ownership.
The outlook for stocks is a bit murkier. I still favor holding a global portfolio, with the thought that owning equities in NIRP regions of the world could add value. It seems more than obvious to own domestic stocks, especially as the growth gap between the U.S. and the rest of the world widens. However, the valuation gap has also grown. A pickup in overall economic growth in the currency union is also expected to boost profits, making earnings one of the key drivers for a rise in the European stock markets. In the current economic backdrop, I favor fixed income from a risk-reward point of view.
In the NIRP world, alternative investments certainly deserve a seat at the table. There are two reasons why managed futures exposure is especially relevant. Its ability to generate profits during periods of market volatility — which also coincides with the perpetuation of price trends — gives the asset class a unique benefit of negative correlation to stocks during down periods and flat to slightly positive correlation to stocks during favorable equity market periods (see Figure 3, below).
Managed futures has also been effective in capturing price trends in raw materials such as crude oil and precious metals, a source of return that is completely unrelated to either the stock or bond markets.
With many countries in a currency war, rushing to devalue their currency in an effort to import inflation, owning gold becomes a rational strategy. This “race to the bottom” with regard to foreign exchange rates should drive capital into the precious metal.
Although I am rarely an advocate for holding gold, the current NIRP world makes it a viable parking spot for cash.
--- Read Investors Try to Ride Out an Improbable Storm on ThinkAdvisor.