Short-term stimulus policies, like low interest rates and excessive liquidity injections, can have severe, long-term consequences for the global economy, as Stanley Yeo explains.
With the onset of the Global Financial Crisis (GFC), central banks led by the US Federal Reserve (Fed), have embarked upon unprecedented injections of liquidity into the financial system along with various unconventional mechanisms to support the financial system.
Low interest rates and quantitative easing have become a panacea for economic problems. In part, this reflects the limited flexibility of governments to run budget deficits.
This is driven by increasing scrutiny of public finances and the lack of willingness of investors to finance such deficits, as highlighted by the ongoing European debt crisis.
Five years on, we believe the various measures have had their intended outcomes. Whilst problems still exist, the financial system has largely been stabilised, economic growth has been sustained in a number of countries, and asset prices in a number of cases have reached all-time highs.
Another positive consequence of ultra-low rates is that over time, low interest rates allow governments to refinance, erode or liquidate their debt, making it easier to live within their budgets without having to resort to more unpalatable spending cuts or tax increases.
Since the Fed has set its benchmark interest rate at zero, the Government has saved trillions of dollars in interest payments.
It can also be said that the Fed has been too successful. Interest rates have been pushed down to historic lows in many countries and whilst there has been significant asset price inflation, there has been little inflation based upon wages and traded goods.
In fact, the rally in equity markets in the US from the low point in the GFC till now exceeds the rally that occurred in the period from 2002 till 2007. So is there a problem? Indeed, we believe that ultra-low interest rates have had many unintended negative consequences.
Asset price bubbles
In the past under Alan Greenspan, asset price inflation was not seen as a problem because it did not flow through to wages and goods.
But, as we know from the global financial crisis (GFC), the collapse of asset price bubbles can have significant impacts upon the real world economy. We also know that huge pools of liquidity will lead to money flowing to areas of least resistance and areas with the potential for the highest returns, thus often leading to asset price bubbles.
Do we have asset price bubbles now and, if so, where are they located? We believe low interest rates in the developed world have had spill-over effects in emerging markets, pushing up exchange rates, causing asset bubbles (such as Chinese property) and, inflating emerging market debt.
Closer to home, property, especially residential property, has been the other large beneficiary of lower interest rates.
It is debatable whether or not there is a bubble in residential real estate but it is no longer cheap, and any significant increase in rates would surely impact this sector.
Artificially propping up house prices locks future generations out of the housing market, distorts rental costs and delays the banks and building societies recognising their losses.
What about a bond bubble?
We believe interest rates are unsustainably low in the sovereign space, as central banks have distorted the markets by pushing rates down below their long-term equilibrium rates.
Whilst long bond yields have backed up from their historic lows, they still have not reverted to their long-term equilibrium levels.
Our forecasts indicate the long-term equilibrium rate for US Treasuries is 4 per cent. Thus, more pain is likely at some stage.
With yields so low, we believe it is debatable whether bonds will still provide the same level of protection in an economic downturn compared to when yields were higher.
Our opinion is that for bonds to rally much from here, we would need to see another GFC type event. But how often do these events occur? We would not expect another crisis so soon!
Search for yield
The yield being generated from bonds and cash has been so low that for retirees, and others who require a certain level of income, the yield has not been sufficient.
As such, these people are forced into other instruments which may be riskier or which create a bubble in these instruments. Thus, there has been a shift into term deposits, hybrids and corporate credit.
As more and more money is invested into these instruments, rates get competed down and there is a danger that bubbles emerge and that investors increasingly take up more equity-type risk in order to earn a higher yield.
Driven by low rates, Australian investors have increased investment in complex capital securities issued by banks and corporations, taking on additional risk, which they do not fully understand, to generate higher income.
The increased search for yield has also resulted in an increased appetite for high-yielding equities. With yields of 4 to 5 per cent on average in Australian equities, and once grossed up for franking credits, the yield equation looks very attractive for equities.
Companies have recognised that investors are look for higher yields, and as such, payout ratios for Australian equities are at 30-year highs.
Companies that pay and maintain high dividends tend to be rewarded by the market. Another part of the equation is that self-managed funds (now the largest part of the superannuation system) have a major preference for high-yield stocks, such as banks.
The consequence of this search for yield is to push up the price for equities and the demand for high yield stocks.
Pleasingly, most markets are fairly rated despite a good run in prices. In fact, the rally from 2009 till now has been greater than the rally from 2002 to 2007/8.
Despite this, valuations as measured by P/E, price-to-book and yield are not overly excessive.
Implications for investors
Investors need to be cognizant of the risks they are taking on in their portfolios as they chase yield in investments that have reached, or are close to, bubble territory.
When rates eventually do rise, many of these investments will likely be hit, as investors pull their money out.
Investing for the long term should focus on the fundamentals and instead of fearing a rise in interest rates, investors should focus on the positive message that this is sending - that is, the economy is on the rise which will lead to job growth and increased corporate profitability.
Implications for corporations
The implication for companies that are paying out a large proportion of their profits and dividends is that they have less to invest internally for organic growth.
Some studies have shown that after periods of very high dividend payments, earnings decline as a result of under-investment in the business.
Another consequence is that corporations also seek higher returns and react to artificially low rates by buying back their own shares (either with existing cash or with dollars borrowed at the artificially low rates) to reduce the inventory of shares available on the market and thereby increase their earnings per share, rather than to invest in their businesses.
This comes at the expense of muted job growth, which partially explains why the economy is showing limited growth but the stock market is hitting record highs.
Effectiveness of low rates
On top of having many unintended negative consequences, ultra-low rates may also be ineffective in addressing the real economic issues.
Financial markets have generally reacted positively to low rates, pushing up stock prices. But low rates point to a worrying lack of growth.
Low rates also highlight the increasing risk of deflation and a severe contraction in economic activity. Given that growth and inflation are among the primary requirements for a relatively painless reduction in elevated debt levels globally, the enthusiasm with low rates and quantitative easing among investors is curious.
The clear hope is that low rates will revive the economy. The theory predicts lowering rates will boost bank lending and increase access to credit for purchases of homes or other goods and services, ensuring economic recovery.
However, the reality is quite different. In Australia, Reserve Bank research indicates that the savings from lower mortgage rates are simply being used to retire debt, rather than for consumption.
While the reduction in debt levels is necessary, lowering rates will, of itself, do little to boost demand and economic activity.
Meanwhile, older savers’ and pensioners’ incomes have been squeezed by falling rates leaving them poorer. Savings rates have lagged behind inflation, reducing real incomes, eroding the real value of savings and lowering consumer confidence.
Fearing for their financial future as their current or prospective incomes plummet, many have cut spending.
Misallocation of capital
Another problem that low rates might provoke is to tempt borrowers into ignoring their balance-sheet problems.
The result could be that the problems are left to fester, making it difficult for central banks to raise interest rates to a more normal level in future years, for fear of the damage this might cause.
Banks may also become too optimistic about the ability of borrowers to repay, and fail to make adequate provisions for bad debts.
When investments are made during a period of artificially low interest rates they are often ‘malinvestments’ as the low rates may send false signals to entrepreneurs and home buyers that the economy is good and investments/purchases should be made.
The term ‘malinvestment’ is a concept developed by the Austrian School of economic thought, that refers to investments of firms being badly allocated due to what they assert to be an artificially low cost of credit and an unsustainable increase in money supply, often blamed on a central bank.
The Fed has driven interest rates down precisely because the economy is not doing well - and to encourage entrepreneurs and consumers to employ capital in places they otherwise might not spend or invest.
In conclusion, the unprecedented moves by central banks which were necessary to stabilise markets have had the desired effect of stabilising the financial system in the short term. The issues stem from the unintended consequences of these ultra-low rates.
Large amounts of existing and borrowed capital have flowed into the stock and real estate markets chasing assets that are rising in price, not necessarily based on fundamentals but on the notion that they are rising and the potential returns are greater than low interest bearing investments.
Without alternative places to put their money and armed with the false understanding that rising stocks and real estate prices mean the economy is doing well, people will pour money into the real estate and stock markets chasing them higher.
Perhaps if governments relied more on fiscal policy rather than monetary policy, some of these negative side effects of ultra-low rates may be avoided. Investors need to be mindful of the risks that have been built up and be nimble enough to take advantage of the opportunities that will inevitably emerge.
Lord Maynard Keynes was a proponent of stimulating the economy to bring forward demand when the economy was in recession.
In reaction to criticism that stimulus spending would, in the long run, create problems further down the road, Keynes remarked ‘in the long run we are all dead’. The problem with this type of thinking is tomorrow often comes and the debts of yesterdays’ excesses must be paid for.
Stanley Yeo is the portfolio manager for strategy and international equities at IOOF.