For this week’s Market Commentary, I am including an excerpt from the second-quarter edition of our quarterly newsletter, The Farr View. We hope you will find it insightful.
The Repercussions of Ultra-Low Interest Rates
There are far-reaching consequences for the central bank largesse that has characterized the post-financial-crisis era. We’ve talked a lot over the past several years about the effect of sustained low interest rates on asset prices. To summarize, low interest rates effectively force investors into riskier assets, thereby inflating asset prices, producing moral hazards (situations whereby investors become emboldened to assume more risk because they feel protected against investment losses), and ultimately creating asset bubbles that tend to burst. We’ve seen this happen repeatedly over the past 20 years. And still today the Fed, and other central banks following the Fed’s lead, continues to rely exclusively on the same old failed playbook. Simply said, negative interest rates across much of the developed world are not a positive sign of anything. They reflect a stubbornly persistent dearth of aggregate demand and the increased desperation of central bankers.
Aside from financial asset bubbles, there are other dramatic implications of sustained ultra-low interest rates. A sizable chunk of the global investor base consists of investors requiring a certain amount of income from their investments. Here we are thinking about retirees and pension funds in particular. Over the past 35 years, the yield on the 10-year Treasury bond has dropped precipitously to its current near-record low of about 1.47%. The S&P 500 is now in the uncommon position of offering a dividend yield significantly higher than the 10-year Treasury bond. Faced with accepting just 1.47% annually for the next 10 years, many yield-starved investors are opting to trade out of bonds and into high-yielding stocks. This is what the pundits mean when they say that the Fed is forcing investors into “risk” assets.
Should pension funds and retirees be dramatically raising their exposure to stocks following a 200%+ move upward over the past seven years? Maybe, or maybe not. The purchase of a 10-year Treasury bond at today’s interest rates entails its own risk – interest rate risk. If and when interest rates increase, the value of longer-term bonds could fall dramatically, catching some investors off guard. Given the yield disparity, some investors are seeing a better risk-reward profile from high-quality stocks. We generally agree. However, it is worth pointing out that otherwise highly risk averse investors like pension fund managers and retirees are forced into this dilemma.
Sustained, ultra-low interest rates also lead to poor business decisions, overcapacity, and the perpetuation of enterprises that should have been allowed to fail. One need only look at Japan’s economy over the past three decades to see how easy money can inhibit economic growth by supporting uncompetitive companies that should have gone bankrupt long ago. The best recent example in the US is the massive expansion in energy exploration & production, which has led to a surge in bad debt as oil prices plummeted over the past couple of years. We would also attribute much of the overcapacity in retail stores to the proliferation of cheap money (as well as new competition from the internet). The fallout of this over investment, as we have seen in both industries, is painful and ongoing.
I would be remiss not to mention higher education in this discussion. Ultra-low interest rates, combined with easy access to government-guaranteed loans and big reductions in state funding, have caused a huge spike in both the cost of college tuition and student debt outstanding. According to the Federal Reserve, student debt outstanding has nearly tripled over the past decade to $1.35 trillion. The web site StudentLoanHero.com says that “the average Class of 2016 graduate has $37,172 in student loan debt, up six percent from last year.” Graduating college students are being saddled with big debt burdens, which are not dischargeable in bankruptcy, and that they have little hope of ever repaying. This issue could have profound social consequences as our younger generations find it exceedingly difficult to buy or rent their own place, buy a car, get married and have kids. Something has to give.
Finally, sustained ultra-low interest rates have the effect of pulling forward future demand and reducing our economic growth potential in the future. A good example is the auto industry. Despite still-high consumer debt levels and scant income growth, auto sales were at an all-time high last year (eclipsing the previous record set 15 years ago). Why? Because low interest rates (and loosening credit terms like 0% interest and extending loan durations up to 7 years) have reduced the cost of ownership. Well, that was great for the economy in 2015, but what does it mean for the next several years?
Which brings me to the issue of consumer debt. I’m always puzzled when I hear the pundits on TV talk about how much healthier the consumer is now because debt levels have been reduced. The reality is that all the debt in our economy is fungible. Sure, the absolute level of consumer debt may have gone down modestly, and debt service ratios (the ratio of total required household debt payments to total disposable income) may have dropped significantly due to low interest rates. But there are some glaring problems with these metrics. First, consumer debt has gone down in large part due to a surge in federal government borrowing to pay for stimulus measures and transfer payments (unemployment insurance, food stamps, Medicare, Medicaid, etc). Eventually, the federal government’s debt will have to be paid off by guess who? Taxpayers. Secondly, looking at aggregate data like these masks the fact that the lion’s share of the income and spending gains that are taking place in the economy are attributable to a very small fraction of well-to-do people.
We have long held that the shrinking middle class, stagnant middle-class incomes, and the ongoing widening in the wealth and income gaps have profound implications for not only economic vitality, but also for social stability. Our stance is not now, nor has it ever been, a political one. We simply believe that an economy is more likely to reach its full potential if income and wealth are more equally spread over a broader portion of the population. It doesn’t take a PhD in Economics to see that more money in the hands of those who will spend it is better for the economy than the alternative. The growing attention to this issue has been glaringly obvious not only in the US but across the world.
Most people think that the modern-day “populist movement” began in the US with the creation of the Tea Party in 2009, when advocates of limited government began to protest against the government bailouts for “Wall Street fat cats”. But the gap between the haves and the have-nots has actually been growing for much longer, and the evidence of the problem continues to accumulate. The Tea Party movement spawned the Occupy Wall Street movement in 2011, which consisted of a series of nationwide protests more intently focused on the specific issue of economic inequality. Since that time we’ve seen a number of global developments that can be either directly or at least tangentially tied to the issue of economic inequality, including the Arab Spring in the Middle East; the riots in Baltimore, MD and Ferguson, MO; the water quality issue in Flint, Michigan; the surging opiate dependency rates in rural America; the successful primary campaigns of Bernie Sanders (an avowed Socialist) and Donald Trump (an advocate of protectionist trade policies and restrictions on immigration); the Black Lives Matter campaign; and now the Brexit. Each of the above at least partially reflects the growing perception that the well-to-do are reaping all the spoils of the economic recovery while the middle class languish.
Say what you will about the British, but they certainly have moxie. The British electorate passed a referendum that their own government said would very likely lead to a recession and reduce the size of the economy by 6% (compared to the status quo) by the year 2030. According to an April 18 article in The Wall Street Journal (“Brexit Would Lead to 6% Drop in UK GDP, Government Warns”, by Jenny Gross and Jason Douglas), this reduction in the size of the economy “would be a loss of income equivalent to $6,107 a year for every British household.” Yet the electorate still passed the referendum. Why would they do such a thing?
An excellent post-referendum article by George Friedman of Geopolitical Futures said that the vote’s outcome came as such a surprise because the political establishment lacked the imagination to appreciate the magnitude of public dissention. And Mr. Friedman believes the Brexit lesson applies to other countries as well: “What has become universal is the dismissive attitudes of the elite to their challengers. It is difficult for the elite to take seriously that the less educated, the less sophisticated and the less successful would take control of the situation. The French Bourbons and the Russian Romanovs had similar contempt for the crowds in the streets.” Friedman goes on to say, “The distance between what I will call the technocratic elite and the increasingly displaced lower-middle class and even middle class is becoming one of the major characteristics of our time.”
And so the Brexit outcome can best be understood as a manifestation of the growing gap between the haves and the have-nots – a repudiation of the status quo by those who neither benefited much from Britain’s inclusion in the EU nor expect to suffer much from the Brexit. It is an expression of hopelessness, disenfranchisement, and marginalization like so many of the movements we’ve seen in the US over the past decade. The message has been sent to the Republican party in the form of Donald Trump, and to the Democratic party in the form of Bernie Sanders (even though he won’t get the nomination). What’s clear to me is candidates had better start paying more attention to these struggling masses.
That’s great Mr. Farr, but what do you recommend we do about this problem? I’m no expert in public policy, but I believe we have the capacity to address the growing problem of economic inequality. As I’ve said in the past, I think the key to the re-enfranchisement of the middle class begins with greater public investments in education and infrastructure. But the first step in increasing these expenditures must be a definitive resolution to the long-term problem of entitlement spending. If Congress were to pass legislation that raises the retirement age for Social Security and means tests Medicare benefits, for example, this would provide much-needed budget flexibility over the intermediate term to invest in education and infrastructure. I believe it’s as simple as that. And while I admit that the dysfunctional state of Congress and the likelihood of a polarizing new President don’t help matters, I remain optimistic that we as a people will rise to our formidable challenges.
In the meantime, we remain fully invested but defensive. As stock prices hover near record territory and Treasury yields sink to all-time lows, now is a time to be diligent with regard to portfolio composition. As previously noted, we believe many investors are underestimating the risks associated with owning long-duration bonds. At the same time, we think the upside in stocks over the near term is fairly limited given full valuations, ongoing margin pressures, and the concerns over the Brexit and the presidential election on November 8. Yet there is value to be found for those willing to employ a long-term approach to investing. Above all, we strive to drown out the noisy headlines that can cause near-term volatility but are very often irrelevant to a long-term investment thesis. We will stick to this course.