Negative Interest Rates: Carry an Umbrella at All Times


Bankers Stunned as Negative Rates Sweep across Danish Mortgages.

Yes, this sensationalistic headline is true. Negative interest rates are available in Denmark on adjustable-rate mortgages with durations under five years. So after paying some upfront fees, borrowers on these loans effectively receive a thank you payment from the bank every month.

How can this be? Why would lenders pay borrowers instead of charging them interest? To describe this upside-down world, the Mock Turtle in Alice’s Adventures in Wonderland would say “Well, I never heard it before but it sounds uncommon nonsense.”

So how did negative interest rates come about? Should portfolio managers change their game plans because of them? And if so, how?

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Let’s review the history. Negative interest rates first became a major phenomenon in 2014 when the European Central Bank (ECB) decided to pay commercial banks a negative rate on the deposits they held at the ECB. The Bank of Japan (BOJ) followed suit. These actions led to negative rates on European and Japanese government bonds. Over the years, the value of negative-yielding bonds has soared, going from zero to over $12 trillion.

Central bankers are encouraging savers to spend their money or invest it in something riskier than bank deposits and money market funds because they are obsessed with generating economic growth. They worry that anemic expansion will lead to deflation and that deflation will create a downward spiral of more negative growth and more deflation, as it did during the Depression era of the 1930s. By forcing savers to spend and invest, the bankers hope to spur economic growth and stave off the dreaded deflationary spiral.

Have these efforts succeeded?

Growth in Europe and Japan has actually been tepid, calling into question the wisdom of the negative interest rate policy (NIRP). In their defense, the central bankers contend that growth would have been even worse and that the economy could have plunged into the dreaded deflationary spiral had they not adopted such drastic measures.

There is no firm consensus on how these monetary policies affected economic growth. But there is broad agreement that they have indeed propped up the prices of stocks, bonds, real estate, and other risky assets over the last few years.

The US Federal Reserve moved in tandem with the ECB and BOJ for many years following the global financial crisis (GFC). But thanks to stronger growth in the United States, the Fed diverged from its counterparts and raised short-term interest rates up until the beginning of this year. In recent months, the Fed has signaled that it will once again start cutting rates due to concerns about weaker economic growth.

In light of central bankers’ aggressive activism to drive interest rates so low, portfolio managers should consider the following questions and our subsequent analysis:

Will central banks reduce interest rates further? How low can they go?

Yes, more rate cuts are likely. Recent statements from Jerome Powell, Mario Draghi, and Christine Lagarde clearly indicate as much. They will keep going until one of two things occur:

  • Either economic growth increases and inflation is consistently above the 2% target,
  • Or something breaks in the financial system that sends the clear message that the market will not tolerate such low interest rates.

Are there downsides to the central banks’ recent measures?

The negative consequences are well-documented. Loose monetary policy has introduced market distortions, artificially incentivized risk taking, penalized savers, increased inequality, and strained pension funds. In some cases, those suffering from these effects have also benefited from higher asset prices and lower interest costs. Still, the doomsday scenario that experts feared most — runaway inflation — hasn’t materialized. Yet.

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Should portfolio managers consider adjusting their investment strategies?

Yes, portfolio managers should think about these monetary policies and their likely future path and determine whether their clients have a sufficient margin of safety if the gathering clouds threaten to burst. Below are our offer specific suggestions and the rationales behind them.

Equities: We recommend underweighting both debtors and creditors, unless their valuations become more compelling. Why? First, because many highly indebted companies have survived thanks to low interest rates. A business that relies on the mercy of the central banks is not an advisable one to own. As for the creditors, or banks, low interest rates reduce their profitability. Moreover, since banks apply substantial leverage in their business, they will be the first line of defense should the financial system start to take on water. By contrast, we see less downside in overweighting companies with stable, free-cash-flow-generating businesses with moderate levels of debt and reasonable valuations.

Fixed Income: Instead of the conventional path of intermediate duration, investment-grade corporate and mortgage-backed bonds, we suggest designating a portion of fixed-income assets to Treasuries as a hedge against deflation. The capital preservation portion of the portfolio should be Treasuries only, rather than broadly diversified money market funds. Those concerned about the possibility of runaway inflation should also consider investing in Treasury Inflation-Protected Securities (TIPS).

Real Assets: We advise gaining some exposure to real (physical) assets — commodities and precious metals, for example — and companies that own such assets. These provide diversification benefits and some, like gold, have potential safe-haven properties. Over the last few decades, modern portfolios have shunned gold because it doesn’t produce any income and, therefore, the opportunity cost of holding it was significant. In the current era of low and negative interest rates, that opportunity cost is less of a factor, thus highlighting gold’s diversification benefits.

Of course, one last question is worth considering:

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Could concerns about these monetary policies turn out to be unnecessary?

Yes, that is is indeed possible. The central banks might successfully engineer economic growth, generate moderate but manageable inflation, and revert to a narrow, safety-focused mandate rather than their recent activist, growth-at-all-costs approach. But if recent experience is any indication, we doubt that they can achieve such nirvana. So we need to be prepared for the possibility that their efforts won’t succeed. Fortunately, the cost of preparing for such a disruptive scenario is minimal at this time.

Our portfolio strategy recommendations do not require an ultra-conservative, rush-to-cash approach. Neither do we advise any drastic actions with significant real or opportunity costs. Indeed some defensive investments — gold mining companies, for example — may be undervalued, thus allowing us to harvest low beta at a low price.

In Summary

The stock market’s recent performance combined with low unemployment may, at first glance, suggest that the economy is on the upswing and that there is nothing but blue skies ahead. If we stick our heads out the window, it might look like a clear day. Nevertheless, we recommend carrying an umbrella. Right now, it doesn’t cost much and it may come in handy if it starts to rain.

If we wait until the storm comes, it might be too expensive or too late and we risk being caught unprotected in a downpour.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/Clarke Elsby / EyeEm


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Gautam Dhingra, PhD, CFA

Gautam Dhingra, PhD, CFA, is the founder and CEO of High Pointe Capital Management, LLC. He developed the firm’s pioneering investment approach based on the concept of Franchise Quality, and under his leadership, High Pointe has built an enviable investment performance record. Dhingra served on the faculty member at Northwestern University’s Kellogg School of Management for two years. In this role, he designed and taught The Business of Investing course in the school’s MBA curriculum. His research interests include ESG investing and valuation of intangible assets. He holds a PhD in finance, with specialization in investments and econometrics, from the University of Florida’s Warrington College of Business. At Warrington, he taught two courses in securities analysis and derivatives.

Christopher J. Olson, CFA

Christopher J. Olson, CFA, is a principal and portfolio manager at High Pointe Capital Management. Prior to High Pointe, he was a portfolio manager at Columbia Wanger Asset Management in Chicago for 15 years where he managed both equity and balanced mutual funds. He began his investment management career at Yasuda Kasai Brinson in Tokyo in 1991, and later joined the parent company, Brinson Partners, to help start the firm’s emerging markets investment strategy. He has lived and worked in Sweden, Japan, and Taiwan. He is proficient in Mandarin Chinese and has studied five other foreign languages. Olson received an MBA from the Wharton School of Business with distinction and an MA in international studies from the School of Arts and Sciences, both at the University of Pennsylvania. He graduated from Middlebury College with a BA in political science, summa cum laude. He earned his CFA charter in 1998 and is a member of CFA Chicago. His civic responsibilities include his role as chair of the board at Swedish Covenant Hospital in Chicago and as trustee at Lincoln Academy in Maine.



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