We had a rule for 2,600 years... that a bird in the hand was worth two in the bush. These days in Europe, it’s worth 9/10ths of a bird in the bush,” said Warren Buffett at this year’s Berkshire meeting with regard to negative interest rates. “If you’re not confused, then you haven’t thought about it correctly,” Charles Munger added.
Before looking at the consequences of negative interest rates, let us first look at the magnitude of the problem. Bonds with value of $13 trillion are having negative yields right now. Swiss bonds with maturities as far out as 50 years have negative yields. We have had financial companies like Munich Re explore the possibility of storing currency notes in vaults rather than deploy money in the money market or with central banks, at negative interest rates.
The problem is peculiar because economic theory has no answer for this. Most of the time, a borrower faces some credit risk. There is deferment of consumption for the saver or lender. The borrower can, in theory, earn profits out of the borrowed money and, hence, the borrower pays an interest rate to the lender. The interest rates go up and down depending on whether money is expensive or cheap, but rates have never been negative for such long durations and in such large amounts.
So, despite Charles Munger’s warning, let us attempt to answer some questions relating to negative rates and what it means for investments.
Are negative rates logical? Surely not, in my opinion. Italy, which used to be part of the infamous PIIGS (Portugal, Italy, Ireland, Greece and Spain) group of European countries that were supposedly at risk, and which probably has a banking crisis on its hands, has negative yields on its short-term government bonds. The negative rates cannot simply be explained by “flight to safety or quality” because some of the countries with negative rates are not high quality borrowers and the only reason for the negative yields is manipulation by central banks.
Are global negative rates sustainable for long periods? It is said that positive interest rates are to capitalism what heaven and hell are to religion. In the absence of positive interest rates, there is a high chance of all sorts of borrowers and projects coming up to soak up cash. From renewable energy to high speed rail to asset leasing, it is not too difficult to dream up uses for free money. Ultimately, rates will have to move up because the cash will be drained out for various purposes.
What about long drawn out recession or deflation? Many people say that zero rates and negative rates are a reflection of the deflation risk that the global economy is facing. However, if trillions of dollars are going to be put to work to create asset bubbles, there will be a lot of economic activity. The last two booms (information technology in the late 1990s and real estate in the mid-2000s) created many new enterprises, employment and activity. But ultimately, a lot of capital was mis-allocated. But it is difficult to imagine a deflationary scenario in which such easy money is floating around.
What happens to stock prices and other asset prices? There is a basic dichotomy between asset prices and the yields on government bonds. Surely when 50-year Swiss bonds are negative, the stock price of Swiss company Nestle, with an earnings yield of 4% and a dividend yield of around 3%, seems incredibly attractive. What is true for pension funds and depositors is also true for corporations, countries and sovereign wealth funds. If this kind of dislocation lasts for long, mergers and acquisitions activity, share buybacks, leveraged buyouts and asset price bubbles will be back.
Where will the next bubble be? This question is difficult to answer since money flows easily. The place of cheap money may not necessarily be the place where the bubble will get created. For example, Japan has had low rates for a long time, but people borrowed in yen and ran carry trade in other currencies. The bubble was not created in Japan but elsewhere.
What can investors do?
Investors have to take two kinds of actions. At one end, the actions have to be defensive. One does not want to suffer capital losses because of bubbles being created and ultimately bursting. This means that one has to be on the lookout for excesses. It is unlikely that an Indian investor has direct exposure to the negative yielding government bonds. However, many sub-par businesses that seem acceptable in a low interest rate regime look horrible when rates are higher. Hence, if in the Indian context, a business or a project is earning, say, 6-8% return on equity, it could see a huge drop in market valuation if and when the rates ultimately move up.
Also, some unsustainable businesses in the start-up or e-commerce space may run out of funding if money becomes hard to come by. So, the other set of actions that investors have to take could be aggressive in nature. It may be worthwhile to keep an eye on promoters or businesses that are using the current environment to borrow long-term money abroad and lock in to interest rates at current levels. This cash could be used to make acquisitions or create capacity at attractive terms.
While individuals do not have control over monetary policies of various countries and the resulting dislocations, what is under the control of each individual investor is her own behaviour. The path ahead would be to realise that we are in a strange world with low opportunity costs. We must keep our expectations reasonable and, at the same time, not to be drawn into frothy stories that are likely to look horrible in a more reasonable interest rate environment.