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For more than 30 years, interest rates in developed economies have continued to decline. It’s often said that now, finally, they will start to rise again. However, this has not happened. On the contrary, rates are still falling lower and lower. Increasingly, economists are saying that low interest are here to stay, a view which I share. This could lead to opportunities for investors.
For most of the 20th Century, central banks played catch up with inflation. If the economy did well, central banks raised interest rates to cool the economy and choke off mounting inflation, which would have harmed economic growth and consumers’ wealth. But, if the economy slowed, central banks would cut rates in order to lower borrowing costs for consumers and corporations, and so stimulate economic recovery.
However, this pattern seems broken. As can be seen in figure 1, interest rates have been steadily declining since the 1980s. Even in 2019, after 10 years of economic growth following the financial crisis and a year in which multiple European countries reached near full employment, the European Central Bank did not increase its rates. How come?
Example: German government debt (%)
Source: BundesBank, series BBK01.WU0115. The data refers to government bonds with a maturity of at least 4 years at emission of which at least 3 years is open standing. Historical performance is not a reliable indicator for the future. This also holds for historical market data.
Let us start by observing that interest rates are actually prices, namely those of capital. While some companies, governments or individuals need money, others have more than they need. This balance of demand and supply sets interest rates. But both demand and supply are fundamentally affected by a range of macro factors.
Let us start with demand. Here we see that the economy’s productivity rises more slowly than before, implying perhaps there is less demand for money to invest. Economists debate the exact causes, but less availability of credit since the financial crisis, business unfriendly administrative policies and rigid labor protection laws are often quoted1. Furthermore, on the demand side, we see the emergence of a capital-light economy. How many factory startups do you see? Most, nowadays, are related to services, which require less financial capital but more human capital.
Yet there are also major forces at work increasing the supply of capital.
The combined effect is shown in figure 2. Since the 2008-2009 financial crisis, the imbalance between savings and investment has increased significantly.
Source: Banque de France, Low rates: what are the causes and what are the effects for France?, 9 January 2020
Beyond these macro-economic reasons, there is also a political rationale for low rates. By keeping interest rates low, sovereigns can reduce the cost of their national debt, which has been particularly beneficial for southern European states with high budget deficits. This policy, by the way, frustrates the states that have their budget deficits under control. As the Dutch central bank wrote eloquently in its 2015 annual report: “Monetary policy is reaching its limits. (...) This also results in undesired side-effects, such as (...) an addiction to low interest rates.2” And that was five years ago. Since then, no major policy change have occurred. What’s more, the increased state lending because of COVID-19 will give states further incentive to keep rates low.
Source: Banque de France, Low rates: what are the causes and what are the effects for France?, 9 January 2020.
Assuming that interest rates will remain low for a prolonged period, what would be the consequences for investors? I see three potential implications:
1. Equity valuations might remain higher than in the past. Equities are typically valued as a multiple of their earnings. Often a “price-to-earnings ratio” of 15 is cited as a long-term average, to which prices should revert. However, if investors do not have profitable alternative to stocks in the form of cash or bonds, they might be willing to pay higher multiples for equities.3 Higher price-to-earnings ratios will lead to lower dividend ratios. Investors who are still looking for attractive income streams could consider our VanEck Vectors Morningstar Developed Markets Dividend Leaders UCITS ETF. Do note that low interest rates do not change the inherent risk of equities, such as market risk.
2. For bonds, investors might need to accept higher levels of risk, either in the form of credit risk or interest rate risk, in order to achieve decent returns. E.g., our VanEck Vectors Global Fallen Angel UCITS ETF provides access to high yield bonds and yields 5.5% at the time of writing (26 June 2020). An alternative approach could be to invest in emerging market local currency bonds, in countries where sovereign rates still are in positive territory. Our VanEck Vectors J.P. Morgan EM Local Currency Bond UCITS ETF currently yields 4.5%.
3. Real estate will likely benefit from low interest rates. There are two reasons for this. Firstly, real estate investments are typically partially financed with debt. If interest rates are low, the real estate owner’s debt payments fall. Secondly, if there is no profitable alternative in the form of cash or bonds, investors might be willing to accept higher multiples on real estate investments, such as for equities. Our VanEck Vectors Global Real Estate UCITS ETF gives investors exposure to a wide array of real estate sectors, across the globe. Obviously, investing in real estate also entails risk such as concentration risk and political and economic event risk.
“I never make predictions and I never will”, as British footballer Paul Gascoigne once famously said. I will not pretend knowing where interest rates will go. But I think that investors would be wise to think through the consequences for their investment portfolio of a scenario of long-term low interest rates.
1See e.g., ECB Economic Bulletin, Issue 3 / 2017, The slowdown in euro area productivity in a global context. https://www.ecb.europa.eu/pub/pdf/other/ebart201703_01.en.pdf.
2Source: Annual report 2015 DNB, Working on Trust, https://www.dnb.nl/en/binaries/Jaarverslag_ENG_web_tcm47-339389.pdf.
3Or, to express it in more technical terms: the value of a stock equals its expected future dividends, discounted at the sum of the risk-free-rate and the market risk premium. If the risk-free-rate, for which we can use sovereign interest rates as a proxy, drops, the dividends are discounted at a lower rate and the value of the stocks increases
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