Reading Between the Lines

“I would never buy a negative rate bond, not unless I was forced,”
-Jamie Dimon, CEO of JP Morgan Chase

There were some puzzling headlines over the past couple of days that had me scratching my head. Let me start with the president, who had some interesting things to say in a recent interview with CNBC’s Joe Kernen. As usual, he said the economy is in great shape, and investors are making lots of money on their investments. But the president also said that if not for the Fed’s interest-rate hikes during the first half of his presidency, GDP growth would be closer to 4% rather than the current level of around 2%. Is he right? First let me say that I am not being political when I write, but it is incumbent on me to address the economic and investment implications of policy matters.

Most economists would refute the notion that growth would be 4% by now if not for the last 2 or 3 Fed rate hikes. A prohibitively high cost of capital has not been the issue holding back the economy. In fact, there has scarcely been a more abundant supply of low-cost capital in modern history. What’s more, businesses just got a huge tax cut, and rather than invest in future growth initiatives they instead used the lion’s share of the windfall to buy back their own stock. And so it is far more likely that the lackluster growth rates since the Great Recession are the result of insufficient demand. In my opinion, the root cause of insufficient demand has been economic inequality. Again, this is not a political comment. If 70% of the economy is driven by consumers and the majority of consumers haven’t had much more money to spend, then growth will be stifled. In other words, the large majority of the benefits of the economic recovery have gone to a relatively small percentage of folks who can’t generate meaningful economic demand because there are so few of them. Until and unless we see more money in more hands with a higher marginal propensity to spend, we probably won’t see meaningfully higher growth rates.

The president went on to say that the stock market, as measured by the Dow Jones Industrial Average (DJIA), would be 5,000-10,000 points higher if not for the Fed’s rate hikes. This point is hard to disagree with (although the magnitude may be a bit high). More than anything else, the stock market’s performance has been determined by the level of interest rates, and interest rates have been held at artificially low levels for a decade. It’s not hard to imagine that the DJIA would be meaningfully higher if the Fed had not hiked interest rates a total of nine times.

And finally, the president said he would like to see negative interest rates here in the US, because “we’re forced to compete with nations that are getting negative rates, something very new.” Oh boy, do I disagree. First, it is important to note that negative interest rates are not desirable. The reason interest rates in Japan and Europe have become negative is that those economies are growing at a very slow pace, and therefore their central banks have aggressively cut interest rates and bought massive amounts of bonds in an effort to suppress interest rates and jumpstart growth. I’m fairly confident that the governments of those nations with negative interest rates would gladly accept higher interest rates if it meant better economic growth.

The second point to make is that there is a large and growing school of thought that says negative interest rates do more harm than good for the economy. Specifically, negative interest rates make it very hard for individuals (and businesses) to earn a return on their savings, and so they are forced into riskier assets as a way of generating respectable returns. Over time, the rotation into risky assets can, and does, lead to asset bubbles. But perhaps most importantly, negative interest rates wreak havoc in the banking system by dramatically limiting the returns banks are able to earn through the extension of credit. Given that a healthy, thriving banking system is imperative to economic vitality, it’s not hard to imagine the detrimental impact that negative rates can have.

The Fed was not wrong when it started raising interest rates back in late 2015. In fact, they should have started the process years earlier. In raising rates, the Fed was trying to ensure price stability, which is one of its two mandates (the other is maximum employment). It’s hard to argue that the Fed hasn’t done a pretty good job of keeping inflation in a relatively tight range. In fact, our economy has been blessed with very stable prices despite a deflation threat in the years immediately following the Financial Crisis. Now, is it possible that the Fed went overboard in its nine rate hikes over the course of its tightening campaign from late 2015 through 2018? Yes. In fact, we have been saying that the economy can’t withstand meaningfully higher interest rates for many years now. Our fears were reinforced when the yield curve became increasingly flat and then inverted for a short time in 2019. And so it wasn’t a surprise to see the economy slow and the Fed reverse course in 2019. Does this mean the central bank should keep slashing interest rates until they’re negative? Of course not!

Now let me move on to Jamie Dimon, who is the widely respected CEO of one of the largest banks in the world, JP Morgan Chase. Consistent with President Trump’s comments, Mr. Dimon was generally very constructive with regard to the economy and markets. In fact, Dimon said he thought that the markets (and assumedly the economy) are in a “Goldilocks” place right now. He also said that relatively high stock prices are justified by the growing economy. His one concern, however, was the unknown impact of all the Quantitative Easing (QE) we’ve seen by central banks. More to the point, Dimon is most concerned about how the aggressive use of QE has led to negative interest rates in some parts of the world, and the possibility that it could happen in the US. When asked if he sees any financial bubbles right now, he replied, “Only in sovereign debt”, referring to the bonds issued by governments across the globe. Dimon said, “It’s kind of one of the great experiments of all time, and we still don’t know what the ultimate outcome is.” It seems clear that Dimon is apprehensive about aggressive QE and the negative interests rates it has spawned, and he clearly does not want that to happen in the US.

Jamie Dimon knows that artificially suppressed interest rates, especially for extended periods, can heavily influence the prices of all financial assets. Why? Because according to the most basic tenets of finance, the “risk-free” interest rate is the starting point in the process of valuing all risky financial assets. Because nothing is riskless, investors use a proxy for the risk-free interest rate. The closest thing we have is government bonds because governments have unlimited power to either print money or increase taxes (or both) in order to meet their debt obligations. So, when Dimon says he believes that sovereign debt is trading in bubble territory, are we to infer that sovereign debt is no longer a good proxy for the “risk-free” interest rate? If so, we need to use higher interest rates in valuing assets, and doing so results in lower valuations for all kinds of assets including stocks, bonds and real estate. If the Fed were to continue driving interest rates into negative territory, this would dramatically complicate this process of asset valuation. You may hear Fed wonks refer to this type of situation as “financial dislocations.” In any case, these are the type of risks the Fed cannot ignore in implementing monetary policy.

In short, the Fed was right to recalibrate the level of interest rates by cutting rates three times last year. The economy clearly was not strong enough to withstand the nine previous rate hikes, especially given the headwinds from the trade dispute with China. But continuing to cut interest rates into negative territory, as the president proposes, would introduce many new and unquantifiable risks. These risks include a spike in inflation, asset bubbles, damage to the banking sector, and a continued transfer from savers to borrowers. Even without negative rates it is quite possible that, at some point down the line, the extended suppression of interest rates will cause a spike in inflation. Central banks will have to respond by hiking interest rates in an economy with massive amounts of debt. And that probably won’t be pretty. Just because it hasn’t happened yet doesn’t mean it won’t happen. But it is also important to emphasize that there has been very little fallout to date resulting from central bank largesse across the world. This could very well go on for many more years.

Investors continue to enjoy positive markets and modest economic growth. While economic and market “dislocations” are rarely recognized before they are upon us, none are apparent at present. Valuations are full and complacency is settling in. Diligent investors constantly monitor risk, market conditions, economic conditions, and the health of income statements and balance sheets. Our daily, dogged diligence and discipline continue as we pursue strong companies with solid balance sheets. Experience keeps us vigilantly monitoring risk in order to best protect our clients’ interests.