Page 10 - Newcom

10 | INVESTMENT EXECUTIVE Preparing for
the inevitable
The process of returning to normal will be slow because low rates have cut yields on bank deposits
NEWS
January 2020
BY ANDREW ALLENTUCK
what will happen when
interest rates rise? That seems a strange question, for we remain on a downslope of rates drop- ping, which they have done (with a few wobbles) since 1983. Manipulations by central banks have added more money to the supply of loanable funds. The monetary climate within the G-8 seems to be on a permanent Boxing Day sale, and there’s no prospect of that changing any- time soon.
The main reason for interest rates declining is central banks’ policies, such as bond buybacks that have injected cash into the money supply. Demand for loan- able funds has been tepid for investments in such things as energy projects in Canada.
But demand for cash has been strong in corporate finance. Companies have used low inter- est rates to borrow heavily to finance stock buybacks. Interest paid is deductible from operat- ing income. However, with fewer shares, earnings per share and executive officers’ compensation have risen. Rock-bottom interest rates seem to be a win/win to big borrowers.
The process of returning to normal rates will be slow because low rates have cut yields on bank deposits and thus, paradoxically, prodded people to save even more for retirement. Moreover, admin- istered low short rates have had a strong effect on bringing down long market rates of interest.
This low-rate period cannot go on forever, because few people wish to accept being paid noth- ing for postponing consumption.
Eventually, rising interest rates will make companies reverse their borrowing. Companies will see their bottom lines shrink, yet they will have to sell shares to get
money to pay down debt. With more shares to use to distribute income, earnings per share num- bers will drop. That means stock prices will drop.
The world will return to the norm of positive real rates of interest. The problem with this “day of reckoning” theory is that it is an outlier, not part of the consensus. The new view is that lots of cash on the sidelines is a good thing — a merit badge in corporate finance.
“The amount of cash com- panies have is at a record-high,” says Benjamin Tal, deputy chief economist with Canadian Imperial Bank of Commerce in Toronto. “This is not excess cash. Rather, it is what they need to buy into the debt market.”
Under this theory, a strong balance sheet should be cash- heavy. Investors and credit raters like to see lots of liquidity.
Not only do companies not want to part with their cash, the trigger for a rise in short rates is absent. Inflation can push cen- tral banks to manipulate front- end interest rates. U.S. consumer prices in November 2019 rose by 2.1% over those at the same time a year earlier.
In the same month, consumer prices rose by 2.2% in Canada, by 0.2% in Japan, by 1.5% in the U.K. and by 1.0% for the euro- zone; they dropped by 0.1% in Switzerland. Therefore, there is little case for higher administered short rates in the major monetary markets of the world.
between short and long rates] are tight, so there is a limit [to] how much rates could rise.”
Add to that the global savings glut, which has contributed to low rates, and the case for higher rates occurring anytime soon is weak.
Despite the fact that rates won’t rise unless inflation picks up, nominal rates are low or negative in all major countries. Real rates are actually negative in all major markets. Change can happen if increases in government spend- ing are not matched by increases in productivity or taxation.
Alternatively, there could be reductions in globalization that lower productivity and raise costs, says Chris Kresic, head of fixed-income and asset allo- cation with Jarislowsky Fraser Ltd. in Toronto.
economy, such as high-tech, are light on capital, and that also reduces the demand for money.
Eventually, money stored in bills, bonds and banks at a few percent in Canada and the U.S. (or at negative rates in Europe) has to return to being a com- modity that somebody wants. At the moment, low inflation and precautionary monetary policy are restraining the U.S. Federal Reserve Board from raising rates, says Josh Nye, sen- ior economist with Royal Bank of Canada in Toronto: “The Fed’s interest rate policy of rate reduc- tions this year has been about insurance against hits from trade policy.”
When rates do rise, compan-
by low rates will shrink. A return to positive real interest rates will hurt companies that have bor- rowed heavily and benefit a few, such as banks, which have had a hard time making a profit on the small differences between what they pay to borrow and what they charge to lend.
“In [the thinking of] monet- ary think-tanks, negative inter- est rates can stimulate growth. But in the real world, people are not going to save money forever with negative returns on money,” Kresic says.
“Negative rates raise pre- cautionary savings and crush demand,” Kresic adds. “Negative rates are self-limiting. The only question is when the curtain will come down on this odd episode in financial histDoErCy.E”MBER 2009IE
The trigger for higher inter- est rates would have to be a sus- tained lift in inflation rates above 2.0%, says Michael Gregory, dep- uty chief economist with Bank of Montreal in Toronto. “Policy rates
For now, the problem in wealthy economies is excess saving with no way to absorb it in productive enterprise. We remain in a phase during which there is too much money being
INVESTMENT EXECUTIVE
could go lower,” Gregory says. sought by too little enterprise. ies will rush to pay off loans and
“Credit spreads [the difference Moreover, the winners in today’s bonds, and markets engineered
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