Back to the future of zero interest rates

Stock markets are flirting with all-time highs with the S&P 500 a couple of percent off the ATH. 

In this post, let's reflect on the rapid fall in interest rates. Could the zero interest rates we have become familiar with since the financial crisis return? Before that, we’ll talk briefly about a study where professionals proved to be the biggest losers in the spring 2020 crash. Let's also take a look at the US jobs data and correct one misconception about the apparent ballooning of credit card debt.

US labor market remains strong

Friday's labor market data continued the same old story about a reasonably strong US economy. Unemployment fell to 3.7% and a couple of hundred thousand new jobs were created. Wage growth remained at an annual rate of 4%. A strong economy takes the edge off expectations of a rate cut, but the world's most anticipated recession remains firmly out of reach for now.

Looking at the Sahm rule, investors have nothing to worry about yet. According to this rule of thumb, a recession is almost certain when the three-month average unemployment rate rises 0.5 percentage points above recent lows. The Sahm reading is now hovering at 0.3 percentage points, not signaling a recession.

Credit card debt will not balloon as the bears claim

One of the favorite buzzwords of bearish investors in recent months has been runaway credit card debt. However, this is partly an optical illusion. With inflation rampant in recent years, all nominal numbers, including GDP, are inflated. If we look at credit card data in real terms, i.e., adjusted for inflation, there level is lower than before the pandemic or even the financial crisis 15 years ago. In other words, the increase in credit card debt isn’t as alarming as it looks on the surface.

 

Retail investors are not the ones to panic the most

An often-heard stereotype in the stock market is that retail investors would sell in a panic at the bottom. However, empirical experience in recent years doesn’t support this claim, as in Finland, for example, retail investors bought shares furiously in the March 2020 dip and now in the fall dip, according to Nordnet.

Now there is research evidence to support this finding. Instead of the so-called bulleros (Finnish for a baby bull), i.e. unsophisticated retail investors, it’s the funds that are panicking when stock markets crash.

According to a recent study, the funds that lost the most money in the spring 2020 liquidity panic were those owned by other funds run by professionals. In turn, funds where households were the largest shareholder group lost the least. Moreover, the funds owned by most households fell the least in the crash, although the performance gap narrowed in the following boom months.

The data was from Europe, but also in the US, institutions have been found to be more sensitive to panic triggers than retail investors.

In other words, if someone claims that retail investors are panic-sensitive herd animals, show them this graph and point out that the panic-sensitive crowd is probably to be found among the so-called professional portfolio managers. Wearing a suit to work alone doesn’t make anyone a good investor.

Back to the future of zero interest rates

Over the last couple of years, investors were surprised by the sharp rise in inflation and interest rates, causing a proper earthquake in the stock market. Over the previous ten-year period, investors slowly got used to the then new climate of zero interest rates. Now interest rates seem to be falling rapidly again, so it’s worth considering whether we are returning to the era of low interest rates.

This has a big impact on equities in two ways. Firstly: When interest rates are low, there is no competing alternative to equities, so their valuation levels rise. Secondly: Low interest rates are a sign of weak economic growth. Especially for stocks that are dependent on economic development, the period of low interest rates promises stunted earnings growth. For growth stocks, zero interest rates are celebratory news, for industry, banks and other companies linked to the economy less so.

Let's quickly recap what drives interest rates. There are central bank policy rates, with which they try to cool or heat up the economy by influencing, e.g., bank lending rates. High interest rates discourage borrowing and investment, while low interest rates theoretically fuel them. Then we have so-called market interest rates, like the ten-year government bonds of Germany or Finland. In simple terms, these long bonds reflect three things: investors' expectations of economic growth, inflation expectations and country risk. It is hardly a coincidence that the US 10-year bond rate has averaged 6% per year over the past 60 years, while the country's nominal economic growth, i.e., real GDP growth plus inflation, has been above 6%.

A recent study by the Bank of England argues that the equilibrium or neutral real (r*) interest rate in the global economy would be negative 1%. In the study, interest rates are determined by the supply and demand of capital. And that is primarily driven by the increase in life expectancy of the human population. As people live longer, they save more for retirement. These savings increase the supply of capital, which lowers interest rates. Another big driver of a fall in the neutral rate would be a fall in productivity. When investments in, for example, automation are no longer as profitable, the demand for capital decreases. It further reduces the price of money also known as the interest rate.



A negative real interest rate means that the interest rate on government bonds would be below inflation. For example, the German 10-year interest rate would be 1% and inflation 2%. This does not mean that mortgage interest rates would fall to negative levels. At the same time, the aging population and declining productivity growth are trends that are difficult to fight.

The study is naturally sensitive to different assumptions. For example, sovereign debt bloat is estimated to have a negligible impact on interest rates, even though many public economies are living like the union between Argentina and Zimbabwe. Or climate change, an ever-growing menace, could fuel compulsory green investments. Or, if governments invested more in pensions around the world, it could bring down savings rates. The increase in the life expectancy of the population is also seen differently in different studies. Some researchers see that the shrinking labor force is fueling wage inflation. The elderly consume in retirement, while there aren’t enough young people to meet their needs.

During the period of zero interest rates, I often challenged the idea that it was somehow an abnormal phenomenon. According to financial theory, money should always have a price, but if there is an oversupply of capital relative to the investment opportunities in the economy, I see no reason why money should have a high price. This idea is also supported by long-term studies of interest rate movements. I showed this graph in a post years ago. Generally speaking, interest rates have been falling for 700 years. The exact reason is not known, but it may be related to capital accumulation in capitalist systems. If the trend were to continue, the current interest rate cycle would be a fleeting blink of an eye as interest rates sink deeper into the abyss. Time will tell.

 

 Thank you for reading the post! Read analysis and make good stock picks!