Low interest rates are here to stay, but don't expect stocks to re-rate

In a speech delivered last night, Philip Lowe, Deputy Governor of the Reserve Bank, offered a timely reminder that global imbalances continue to depress rates of return available to savers.  Despite the narrowing of current account balances in the past decade, business investment intentions continue to fall short of desired saving.  Faced with the prospect of getting low returns from their deposit accounts, savers continue to look for better returns elsewhere and in the process, have lifted the demand for, and prices of other assets.

Indeed, the persistence of low long term interest rates around the world continues to confound the forecasts of many economists and analysts.  Sovereign bond markets around the world have rallied this year with the yield on US 10 year treasuries declining to below 2.5%.

The bond conundrum and the global saving glut a decade on

Low long term interest rates have had a long gestation period.  Almost a decade ago, Alan Greenspan, the then chairman of the US Federal Reserve, remained puzzled by persistently low US treasury yields at a time when the central bank was lifting official interest rates.

A month later in March 2005, Ben Bernanke attributed unusually low long-term real interest rates to a glut of global saving; an excess of desired saving over business investment intentions.  Alternatively, others described this phenomenon as a manifestation of global imbalances; countries like the USA were running a large current account deficit while Asia and the oil exporters were running large current account surpluses.  An abundance of financial capital meant that there was too much saving chasing too few business investment opportunities.  The price of money or long term interest rates subsequently declined.

The global saving glut had its antecedents in a number of financial crises in 1990s spanning Latin America and Asia, which encouraged governments in emerging economies to save more for a rainy day.  The boom in oil prices also boosted the coffers of oil exporters.  Emerging markets therefore swung from being modest net borrowers of capital in 1996 to being significant net lenders from the early 2000s.

While global saving grew rapidly, there was not a commensurate rise in business investment intentions, which exacerbated the imbalance between saving and investment.  Following the end of the dotcom boom in 2000, the sharp decline in stock prices dampened the appetite of firms to commit to new projects.  The resulting excess liquidity found its way into various assets, notably US treasuries, stocks and mortgage backed securities.

Where have all the safe assets gone?

The global financial crisis lifted the appetite for safe assets precisely at the same time as reducing the available supply of credible safe assets.  The precipitous fall in US home values and collapse of the sub-prime mortgage market made investors wary that US housing was no longer a one way bet.  The market for US treasuries in particular benefited from its safe haven status and liquidity, which continued to attract strong demand from foreign central banks and governments.

Ricardo Cabarello from MIT draws an analogy between safe assets and parking slots to explain why long term interest rates have remained low.  A rise in the number of cars and reduction in available car parks raises the price of parking slots.  Similarly, the financial crisis caused the demand for safe assets to grow sharply and US treasuries were seen as one of the few remaining safe haven assets in the world.

On the investment front, the financial crisis dulled the business sector’s appetite for risk and ushered in an extended period of capital discipline and cost restraint, thus raising companies’ propensity to either hoard cash or pay out higher dividends to shareholders.

Global imbalances have diminished, but...

The IMF has recently re-visited this topic and shown that global imbalances have diminished since peaking in 2006.  Current account surpluses and deficits have narrowed markedly in the past decade; the sum of the absolute values of current account balances has shrunk to 3.6% of world GDP from 5.6% in 2006.  Over this period, the aggregate imbalance of the top 10 deficit countries has dropped by nearly half to 1.2% of world GDP from 2.3%, while the aggregate imbalance of the top 10 surplus countries has declined by one-quarter to 1.5% of world GDP from 2.1% in 2006.  A substantial drop in domestic demand amongst the deficit countries since the financial crisis has been a key driver of their lower deficits.  Nonetheless, at 3.6% of world GDP, the sum of the absolute values of current account balances remains well above the levels that prevailed from 1980-2003. 

The scale of the financial crisis suggests that the healing process is far from over.  Corporate, household and public sectors around the world continue to undertake balance sheet repair, while the slow recovery in nominal GDP across many countries continues to dampen the corporate sector’s appetite for debt, capital investment and new hiring.

Monetary policies in developed countries ought to remain accommodative to address the shortfall in global aggregate demand, revive animal spirits and encourage less saving and more spending, particularly as inflation continues to undershoot central bank targets and cyclical unemployment remains high in most countries.

I’m surprised that the Reserve Bank continues to express frustration at the absence of entrepreneurial risk taking and growth plans across corporate Australia.  After all, top-line growth is weak because the economy remains stuck in a nominal recession; nominal GDP has grown at or below 4% pa in each of the past two financial years, the worst outcome since the early 1990s.  Company results and guidance confirm that animal spirits remain dormant which continues to hinder the much anticipated handover of mining to non-mining capex.  Beset by anaemic revenue conditions, companies justifiably continue to boost profitability by undertaking restricting, selling off underperforming assets, trimming costs and deferring capital spending, and abandoning growth options altogether.

A world of low expected growth and returns = High payout but not higher multiples

Although the reduction in the size of global imbalances is a welcome development, the global saving glut remains with us; excess of desired saving over business investment intentions persists.  This is what bond markets are telling us.  But low interest rates do not necessarily translate into a re-rating of stocks.  From a capital budgeting perspective, the spot risk free rate is low thanks to the factors that are restraining corporate investment: low expected nominal growth and a high expected equity risk premium (ERP).  Therefore, stock multiples should not get an assist from a lower risk free rate given a higher ERP and lower growth prospects .

In a world of low expected capital growth and low expected returns, investors will continue to demand that companies return capital in the form of buybacks and dividends (see my earlier research report, The Cult of Equity).  This obviously does not represent a permanent state of affairs going forward.  Eventually, persistently high payout rates and low retention rates will sow the seeds of the next investment boom as profitable opportunities become more abundant and expected returns from capital expenditure increase.  But the current level of sovereign bond yields around the world and the ECB's timid approach to monetary policy suggests that this remains a way off.

* The charts underpinning the analysis are available on request.