Every dollar in interest paid by a borrower results in a saver receiving a dollar in interest earned. In a “normal” market environment – that is, free from central bank actions – market forces determine the interest rate that clears the market. However, in recent years, we haven’t been in a “normal” market environment and instead have been living in an environment where interest rates have been suppressed. For example, the Fed has maintained near-zero official short term borrowing rates, such as the Fed funds rate, – not to mention the Fed’s quantitative easing bond-buying program – along with similar actions by the European Central Bank (ECB) and the Bank of Japan to encourage more borrowing, spending, and investment.
So let’s consider the counterargument to this current policy; that is, let’s examine the savers in this equation, not the borrowers. For they are the ones deciding whether to save (i.e., invest) a dollar of income, and their incentives may in fact be contrary to what central bankers might hope.
Distorted incentives to save or spend
By keeping rates low, central bankers hope that without the incentive of high rates to keep funds locked away, cash would be siphoned from savings accounts into cash registers. But the opposite may happen instead: as interest income decreases, then consumers saving for, say, retirement may need to increase their savings rate, not decrease it. For the lower the interest rate, the more an investor will need to save to reach their long term financial goals, such as retirement or college.
We can see this in economic data. Consider the following chart that examines interest earned per capita, observing the drop since just before the Great Recession.
As a result of extensive commentary from the Federal Reserve and the European Central Bank that rates will stay low for an extended period of time, investors may believe interest income will continue to stay low – or even decrease, as maturing bonds are reinvested at lower rates. Thus, they may save even more. We can see that in the following chart on the savings rate, which has indeed trended up since the Great Recession. Part of this was due to balance sheet repair, as debt was repaid and consumers favored a stronger personal balance sheet, but part of it may relate to low rates of interest on investments.
Doesn’t the increased savings rate result in more capital available to businesses to invest, such as capital expenditures (capex) on equipment, technologies and processes that can benefit the economy in the long run? While savings should theoretically roughly equal investment over time, banks have been stockpiling their excess reserves (also a large part due to central banks’ bond purchase programs, no doubt) until they have a creditworthy borrower demanding a loan. Right now, businesses have not been borrowing to fund investment. Instead, companies have borrowed to repurchase shares in their own companies to boost stock prices. The following chart indicates business investment has been waning in the past few years. The data in the nearby chart is a proxy for capex, non-defense capital goods excluding aircraft.
A dollar saved is a dollar not spent, and a higher savings rate means relatively lower consumer spending and, indeed, less revenue for businesses to use to invest in capital projects. To wit, revenues are expected to fall 1.4% overall, or rise just 1.7% excluding energy, according to Thomson Reuters. In fact, lowered expectations for revenue growth provide little incentive for businesses to invest further.
But what about the argument that lower interest rates benefit consumers? Low mortgage rates may have encouraged home buying and related expenditures, but lower housing prices following the Great Recession and the increase in employment since then may have been greater factors. Indeed, in data since the 1970s, there is little observable correlation between the homeownership rate and mortgage rates.
Thus, with lower rates may come slower economic growth, and that means lower revenues and profits than would otherwise be the case. Of course, other factors, namely growth of the labor force plus productivity gains, play a large role in determining long-term economic growth, as noted in a recent paper by *Laurence B. Siegel and Stephen C. Sexauer, titled “Five Mysteries Surrounding Low and Negative Interest Rates.”
The authors note that productivity has been weak lately, and lessened revenues provide fewer incentives for companies to invest in productivity-enhancing technologies and equipment. And the aging of the workforce translates into a lower growth of the labor force, which serves to amplify this trend. These softer underpinnings of economic growth may then translate into lower returns on stocks, bonds, and other financial assets, furthering the cycle of low investment returns translating into the need to save more to reach one’s financial goals.
The paper by Siegel and Sexauer further sheds light on these issues. The authors note, “There is little theory or history to suggest that even more zero or negative interest rate policy (ZIRP or NIRP) and quantitative easing by activist central banks will contribute to long-term growth and wealth creation.”
The authors have three key takeaways:
- The current evidence is for low returns. Therefore, investments that appear to have high expected returns will be the exception. Some will have easy-to-see risks. Many will have unseen latent risks. Until the data change, it’s a low-growth world.
- Growth, and high expected returns, will be valued at a high premium. The problem is that everyone knows this and both valuations and volatility will be high.
- Productivity and long-term growth are influenced far more by policies regarding taxes, property rights, and regulation than by any central banking practices. Countries, industries, and companies associated with good policy regimes will grow faster.
Corroborating Siegel and Sexauer is the work by Research Affiliates in its long-term assessment for stock and bond returns globally. In the U.S., Research Affiliates foresees large cap U.S. stocks as measured by the S&P 500 returning 1.3% annually over the next 10 years (adjusted for inflation) and small caps returning just 0.4%, as measured by the Russell 2000 index. And bonds? Just 0.8% real returns over the next ten years, as represented by the Barclays Aggregate Bond index.
Siegel and Sexauer’s work, in conjunction with the quantitative elaboration on the identical theme by Research Affiliates, concludes that we are in a low growth environment. While that may not have been the intention of the Fed or the ECB, artificially low rates may be one contributing factor conspiring to keep economic growth restrained.
As a result, these forces conspire to limit economic growth, though that does not at all mean the economy is in danger of recession or that a bear market is coming. It simply means to adapt one’s expectations to an environment where the economy may grow at a slower pace and the market may deliver more temperate returns than once was the case. Establishing a proper set of expectations is the foundation for establishing any investment strategy.
*Laurence B. Siegel is the Gary P. Brinson director of research at the CFA Institute Research Foundation. Stephen C. Sexauer is CIO at the San Diego County Employees Retirement Association.
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S&P 500 Index - The Index measures the performance of the large capitalization sector of the US equity market. It is a capitalization-weighted index from a broad range of industries, and is typically viewed as a proxy for the broad US equity market.
Russell 2000 Index – The Index measures the performance of the small capitalization sector of the US equity market. It is a capitalization-weighted index from a broad range of industries, and is typically viewed as a proxy for small cap US stocks.
Barclays Aggregate Bond Index – A measure of the broad investment grade U.S. fixed income markets, including Treasuries, corporate bonds, mortgage-backed securities and bonds issued by U.S. government agencies.
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