The Federal Reserve recently issued an opinion that was interpreted by many as a signal for a rate cut at the next meeting. The current interest rate for ten-year Treasury bonds is around 2 percent per year.
However, this return is high compared to other countries. In Germany, the ten-year government bond or bund, as the locals call it, currently yields a minus 0.30 percent. Therefore, every $10,000 German bund returns $9,700 in ten years. In effect, investors are paying the government to hold their money.
Currently, over $10 trillion worldwide is invested in instruments that have negative interest rates. This trend, started by the European Union to stimulate their economy several years ago, has become an end in itself. Countries are fearful of inducing a recession by raising rates. However, the artificially low rates are causing distortions in themselves. Money flows to private equity firms, rather than long-term investment in capital equipment and plants. The low rates seem more beneficial to larger lenders than to consumers. Finally, low rate loans are causing people to invest in such a way as to assume that the low rates will be around forever.
The justification for continuing the low, even negative interest is the presumed lack of inflation in most parts of the world. The implication is that when inflation returns, rates will rise. However, the price impact on a bond with negative interest rates to an environment where interest rates turn positive would be severe. For example, if interest rates in Germany were to go from -0.30 to 5 percent, the value of the ten-year bond would fall to less than 64 cents on the dollar.
Of course, inflation depends on how you measure it. Most governments have a basket of goods for computing the inflation rate, with the prices of each good weighed and calibrated each month. The problem with this approach is that it understates inflation for services. It also ignores, for the most part, the inflation of the stock market, as well as real estate.
The U.S. has benefited from these trends by sustaining a relatively high rate of interest on its debt. This rate attracts foreign money looking for a return higher than offered in their native country. The investment inflows, in turn, help to elevate the value of the dollar relative to other countries since investors have to buy dollars to make investments in the United States. Normally a strong dollar is good for imports but hurts exports. However, currently, the exchange rates between countries are in many instances being overshadowed by the imposition of tariffs, which act to make imports more expensive, while retaliatory tariffs hurt exports.
The one group that loses out all around is the saver. The savers are nominally risk-averse. With returns on safe assets like government debt and certificates of deposit so low, savers are in effect being penalized. Some savers have been going to the stock market for returns, in spite of their risk dispositions not being compatible with fluctuating investments. Others are choosing riskier assets to sustain their level of cash flow.
Also, the U.S. is sustaining a federal budget deficit, which will be around $1 trillion this year alone. This excess spending relative to income tax revenues acts to stimulate the economy. It creates demand that only the government bond market and printing presses can finance. Finally, the slowdown in population growth in the face of the demand for labor will become inflationary at some point, unless a lack of demand makes the economy stagnate.
In essence, low interest rates and deficit spending are taking the place of population growth and exports in moving the economy forward. With everyone from the president to the Federal Reserve trying to keep the stock market moving forward, there is a sense of unreality in the current situation. It does not feel sustainable. When the tariffs against other countries hit home in the form of higher prices of imported goods and foreign markets close as retaliatory tariffs are leveled against the U.S., this situation will feel less abstract and more in need of change.
In the meantime, the party goes on. Until interest rates go up, or something causes the dollar to weaken, the status quo will continue intact. In terms of the investment environment, what we have is parallel to the late 1990s when the dot-com era was ascendant. In those days, the government was running a surplus, which depressed interest rates and made the internet a mania in its own right. Like all investment manias, that one went well until it didn’t.
Overall, economic data is positive, although many people are looking for evidence of the end of the economic expansion. If you look at some data long enough, you can find almost anything – especially true of today, as the trade war’s impact on the economy has been thus far less quantitative than qualitative. Many businesses are making long-term commitments based on the current assessment of the import and export environment. Given the imponderables, some businesses are deferring making any decisions at all at this time.
While the general public is more focused on how much prices will go up at Walmart if tariffs are imposed, a greater impact going forward will be on technology. One conclusion of the trade war with China is the acceleration of their effort to make technology in-house, rather than depend on foreign suppliers. Doing so could have a major impact on this country’s growth. Without the profits from selling technology products to the Chinese, American companies will have to find other outlets or government subsidies to fund their research efforts.
Given the international pressure to keep interest rates down, it would seem that only something international in scope will drive them up. When interest rates go up, it will be a period of sustained inflation. What would cause such inflation is not easy to say, but if and when it was to occur, the impact will be worldwide in scope.
Early indicators of inflation expectations are the price of gold, which has now gone up to $1,400 per ounce, and bitcoins, which have also rallied. A loss of faith in government-issued currency would prove devastating, were such to happen. In some circles, the issuance of currency either in the money supply or as debt, is a precursor to inflation, as more dollars chase the same number of goods and services. Still, there are no compelling data on inflation in the U.S. financial system. Until there is, it will not be an issue.
In addition to the role of inflation in the matter of interest rates, the ability of inflation to impact stock prices is less understood but is a factor in the current environment.
Until perhaps a decade ago, most companies recorded revenue growth of 5-7 percent per year. About 3 percent of this was unit growth, with the balance being price increases or inflation.
Today, most industries cannot raise prices without inflation. On that premise, revenue growth has slowed to unit growth, which has, in turn, been adversely impacted by the slowdown in population growth as well as the population’s aging. Unit growth is currently 1 to 2 percent overall.
In contrast, relatively new industries such as streaming video, cell phones, and internet interactors have commanded very high valuations. Because these firms are new, there is no relationship between their growth rates and the overall economy. When predicting their growth, any number looks legitimate.
For this to change, higher interest rates are needed, which will cause some to question valuations, and an increase in unit growth, which will come from immigration reform and exports. Both factors of unit growth and immigration are political footballs, which may not be sorted out until after the election next year, if then.
Year to date, the stock market has done well, up 15 to 18 percent, depending on the index used. The bond market is up by 5 percent. It is very unusual at this stage of the economic cycle to have both stocks and bonds go up in value.
As stated previously, the assumption currently is that interest rates will stay low, the dollar will continue strong, inflation will remain under control, and people will pay up for the promise of growth faster than the overall economy. Should any of these assumptions be tested and found wanting, prices will likely be reassessed.
Warren M. Barnett, CFA
June 25, 2019