Apr 01, 2016

Wrestling with Negative Interest Rates

I have long thought that negative interest rates didn’t make sense, but monetarists argue that they are just low interest rates carried further.  The theory is that if consumers and corporations have to pay a price to store their cash at banks, they will go out and spend and invest, but it is not clear that is what happens when deposit rates fall below zero.  What is clear is that the outcomes vary by the size and importance of the central bank involved.  In any case, the effects seem to be more temporary than long-lasting.  Perhaps more worthy of examination are the reasons behind the negative rates and what these conditions mean for the long-term economic performance of countries and regions and returns in their financial markets. 

In a survey by ING, more than three-quarters of the respondents said they would withdraw some of their funds rather than incur a charge by the bank for holding them.  One-third said they would keep the cash in a safe place instead of spending.  Strategas Research has taken a look at the impact of negative rates in the places that have used them, like Denmark, Switzerland, Sweden, the Eurozone and Japan.  The performance of the equity markets in those places, and particularly the performance of the financial sector, is almost universally negative after three and twelve months. 

What we all know is that the period following the end of the Great Recession in 2009 has been marked by extreme monetary accommodation and slow growth around the world.  We also know that unit labor costs have been flat until recently and profit margins have doubled, increasing corporate cash balances.  Given that the prospects for accelerated growth in developed countries are modest at best, there is little reason for capital investment in new plants to increase production.  Operating rates in the United States are below 80%, so there is plenty of spare capacity.  The money spent on capital equipment has been used to buy robotics and other tools to provide goods and services with fewer workers.  The result is the world is awash in liquidity waiting for opportunities to put money to work to earn a satisfactory return on risk assets.  Even the consumer seems to have shifted focus from accumulating goods to buying services and experiences.  We all have acquired too much stuff over the years.  Finally, geopolitical uncertainties have put spenders on the defensive.

Very low or negative interest rates seem to result from a number of sources creating too much liquidity and too little growth derived from this surplus.  As I have pointed out in the past, the Federal Reserve balance sheet quadrupled from $1 trillion in 2008 (it took 95 years to get to that level) to $4.5 trillion today.  The balance sheet of the European Central Bank increased from €1.7 trillion in 2006 to €3.87 trillion today.  At a recent Strategas conference, Stan Druckenmiller showed a chart of U.S. debt outstanding.  Composed of high grade and high yield bonds and leveraged loans, it increased from $3.6 trillion in 2005 to $8.1 trillion in 2015, a gain of 120%.  It was easy to raise money in the high yield market and everyone, including a number of marginal companies, was doing it.  Over the past year, however, liquidity in that market has diminished and buying or selling large positions without moving the price sharply has been hard.  In recent weeks, with a better tone to the financial markets, junk bond yields have declined from 10.10% to 8.40%.  Volatility, however, is expected to continue.

During the past year, according to Evercore/ISI, money supply has increased 13.3% in China, 5.7% in the U.S., 5.4% in the Eurozone and 3.2% in Japan.  All this debt and liquidity has only had a minimal effect on growth.  In the 2010 to 2015 period, nominal GDP growth in the U.S. was only 3.5% and real growth averaged about 2%.  What happened to all this money?  Buybacks and acquisitions rose to $500 billion annually, much of which was borrowed.  Confronted with slow growth and limited pricing power, companies resorted to financial engineering to increase earnings per share and investors rewarded their action even though it did not represent real organic growth.  China has also been a player in the game.  Bank assets to GDP were 200% in 2009; they are close to 300% now, while real GDP growth has declined from 20% to my estimate of 5%. 

I have long held the view that monetary accommodation is the least efficient way to stimulate an economy.  Much of that money goes into pushing stock prices higher and keeping interest rates low.  Fiscal spending would be much more efficient in getting economies to expand, but conservatives on both sides of the Atlantic are reluctant to increase government spending.  China and Japan are more willing to do so.

With or without fiscal stimulus, monetary authorities in Japan and Europe have moved forward with more easing.  Japan, in spite of the fact that the country has the highest debt to GDP ratio of any developed nation, has bought bonds to put more money into its financial system to avoid slipping back into a deflationary recession.  In Europe, the European Central Bank recently increased its monthly program of bond buying from €60 billion to €80 billion.  The ECB balance sheet is up €700 billion over the past year and is expected to increase €1 trillion over the next year.  In Japan, the second increase in the value added tax, scheduled for April 2017, is likely to be postponed.  Back in the U.S. the Fed may have delayed an increase in the federal funds rate that was expected in March, but they are not letting the bonds purchased in the 2009 to 2014 period roll off; they are replacing them as they mature and keeping their balance sheet steady at $4.5 trillion.  While their talk, until recently, has been somewhat hawkish, the Fed is more accommodative than it would seem.

Investors are concerned that with monetary policy already easy and fiscal spending hard to achieve, policy makers have few options to keep their economies growing in the event of a financial shock of some kind.  Japan, in spite of having denied the possibility, chose to implement a negative interest rate policy because the yen was strengthening and commodity prices were lowering long-term inflation expectations.  Real interest rates rose and it seemed that Shinzo Abe’s three arrows, consisting of fiscal stimulus, monetary accommodation and regulatory relief producing growth, were not working.  In Europe weak markets and questionable bank earnings forced the ECB to take action.

Unfortunately there are unintended consequences of negative interest rates.  According to The Bank Credit Analyst, banks are, in reality, reluctant to charge depositors for placing funds in their custody.  Bank profitability may be hurt and the willingness to make loans may decline.  Where banks choose to pass the cost along to consumers and corporations, depositors may keep more cash on hand rather than in their accounts, depriving banks of assets to make loans.  Negative rates would reduce the demand for commercial paper and hurt insurance companies.

The countries that have been using negative rates for some time like Sweden, Denmark and Switzerland, have experienced few adverse economic effects from the policy, but the belief is that bank profitability will be impacted over time.  In major European economies like France and Germany, which have large international loan portfolios, the shrinkage of deposits and profits may inflict greater damage.  In Japan, the unintended immediate impact was the yen strengthened and the stock market went down.  As for the United States Janet Yellen sees only limited benefits and other members of the Federal Open Market Committee are not enthusiastic. 

My conclusion and that of The Bank Credit Analyst is that negative interest rates will have a limited positive effect on the economies of Europe and Japan.  Low interest rates have not encouraged consumers to spend aggressively, so negative rates may only provide a modest boost.  Economic and geopolitical uncertainties may cause consumers and corporations to pay down debt and maintain cash reserves rather than spend vigorously.

Negative interest rates have suggested to some investors that public and private institutions are desperate to encourage borrowing and spending to avoid deflation.  I regularly speak before large groups of asset managers and I almost always get a question about deflation resulting from recessions such as the ones we had in the 1930s and in 2008-9.  I believe deflation is largely a function of declining wages and falling home prices.  While there is great concern that we are in a period of secular stagnation that will increase the prospect of deflation, right now wages and house prices are rising.  I actually believe a year from now we will be talking more about inflation.  There is some evidence we may be at or close to an inflection point on inflation.  The Atlanta Fed reports core inflation for February at 3% and the Cleveland Fed reports median consumer prices rising 2.9%.

Fear of deflation is probably rooted in the sharp drop in oil and other commodity prices in this cycle.  Because the prospects for world growth acceleration over the near term are dim, commodity prices are not expected to rise until demand from population growth and economic expansion puts pressure on production.  This may be several years away.  In my view, events are starting to shift toward inflation.  The most important commodity in the world, oil, may have bottomed with its recent move below $30.  Other commodities have also rallied, improving the performance of emerging market equities.  Chinese demand is the main driver of commodity prices and the Chinese producer price index began to stabilize in the fourth quarter.  According to Evercore/ISI, there is an 85% correlation between the producer price index and nominal GDP in China, reducing the prospect of a hard landing there. 

While manufacturing may be in a recession in the United States, there is evidence of an increase in inflation in services.  Evercore/ISI reports that the core personal consumption expenditure index increased 1.7% year-over-year in January. The core services index has increased from 2.4% to 3.0% during the past eight months.  Wages are also increasing.  The labor market is getting tighter, as shown by the fact that initial unemployment claims have been below 300,000 for the past year.  Payroll employment increases have averaged 222,000 over the past three months and average hourly earnings are increasing at an annual rate of 2.5%.  The National Federation of Independent Business reports that it is difficult to find quality workers, so we can expect the positive wage trend to continue.  The JOLTS index of employees quitting their jobs has moved up, which clearly reflects a high level of confidence in the work force.  In Europe, beset by its refugee problem, industrial production is increasing over 2% month-to-month and 3% year-over-year.  OECD Leading Indicators are, however, still headed down. 

Although I still believe 2016 will be a difficult year for the world economies and their equity markets, I think some of the demons that influenced the equity environment in January seem to have quieted down.  The prospect of a worldwide recession has receded.  While there continues to be deflationary pressure on a global basis, the U.S., which is the largest economy in the world by a factor of two, is showing some inflationary signs.  The junk bond market, which was in disarray, has modestly improved. 

There are still many unsettling conditions out there, like the U.S. presidential election and its related uncertainties, and the fear of terrorism.  The attack in Brussels is certain to have a negative effect on the European economy.  It will make both consumers and corporations more cautious in their spending.  In the United Kingdom it increases the likelihood of a vote to exit the European Union in the referendum on June 23, but I still do not think that will happen.  Across Europe, there is likely to be a further political shift to the right.  The world was adjusting to a slow growth environment, recognizing that it may only produce limited investment opportunities.  Many think Paris and Brussels will quickly fade in investor consciousness, but I believe, at a minimum, the steady growth outlook is over, at least for a while.

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