It surprising that many people
fail to grasp the existence and the impact of negative interest rates. It is
often stated that negative rates are a short-term anomaly. In fact, they are
neither. Negative interest rates are a
logical outcome of economic circumstances, they could last for many years even
decades and they are likely to spread to many more countries in the next few
years.
Negative interest rates are
nothing new, it is just that in the past they have been hidden by high
inflation rates. When adjusted for inflation, there have been many instances of
negative rates. For example, during the 70s, real interest rates in the UK were
negative for 9 out of the 10 years. Now that most developed countries are in a
period of low inflation, nominal negative interest rates have appeared.
What drives interest rates to go
negative?
To understand negative interest
rates, it is easier to think in non-monetary terms as money is a derivative measure
of the value of products and services and as a result confuses the picture.
Once you understand negative interest rates in the world of barter, it is then
an easy leap to understand them in a monetary based economy.
A barter example
Imagine the following scenario:
Following a plane crash, a middle
age man and a boy are marooned on a deserted island. Every day the man climbs 3
coconut trees and gets 3 coconuts, one for the boy and two for himself. There
are very many coconut trees on this island, but unfortunately each tree yields
only one coconut at a time. After a few days stuck on the island, it becomes clear
to both that they won’t be rescued, and they are likely to be stuck on the
island forever.
The man makes the following offer
to the boy: “For the next 10 years, I will climb three trees every day and get
3 coconuts: 2 for me and 1 for you. I am bigger than you, I need to eat more”.
The boy is not entirely happy but asks “What happens after 10 years?”. The man
replies “After 10 years, I will be tired and old, but you will be a strong
adult by then and so you will climb up the trees and get 4 coconuts each day: 2
for you and 2 for me. After 10 years of doing that, the debt will be paid”. The
boy was not too happy. “That doesn’t seem fair. I will be getting you double
the coconuts than you got me”. The man explained: “ah, that is because of the
time value of coconuts: a coconut in the future is worth less than a coconut today.
I am taking a risk that one of us might die before the debt is fully repaid
that is why you must repay more coconuts.” The boy was not convinced but promised
to think about it.
A few days later another man, of
similar age to the 1st man, is washed up on the shore. He gets his
own coconuts from the trees, and soon hears about the arrangement between the
first man and the boy. Realising he too is marooned for the long-term, it dawns
on him that the 1st man is very wise to start making arrangements
for his retirement: the boy is a pension scheme. So, he offers the boy the
exact same deal. The boy thinks about it and asks the 2nd man “why
would I choose your deal over the deal with the first man? They are both the
same!”
A little later, the boy addresses
both men and offers them the following deal: “for the next 10 years, every day,
the 2 of you will get 3 coconuts each, and you both give me one each. I am a
growing boy and I need 2 coconuts per day not one. Then after 10 years, like
you, I will get 3 coconuts a day: 2 for me and 1 for the two of you to share.
You won’t be climbing trees anymore, so you won’t need to eat as much. In the
end we will all have collected the same amount of coconuts so that is fair.”
The two men are outraged by the
cheeky boy’s offer. “How can it be fair that we get back fewer coconuts than we
gave you?” Asks the first. “What you propose is equivalent to a negative
interest rate” protests the second man. “Remember the time value of coconuts!”
exclaims the first man.
“I am too young to understand the
concept of time value of coconuts, but I do understand the law of supply and
demand. Right now, the demand for coconut fetching services in the future is
greater than the future supply. So, that is the deal, take it or leave it.”
Had the young boy not made such
an aggressive proposition, the chances are that the 2 middle aged men would
have entered a bidding war for the boy’s future services and the outcome would
have probably been the same.
Interest rate dissected
The second man is right when he
complains that the deal offered by the boy implies a negative interest rate. Over
10 years, he will supply the boy with 3650 coconuts and will only get half that
quantity back 10 years later. The interest rate here equates to roughly minus 7
percent per year – a pretty poor return on investment.
Assuming no inflation, an
interest rate is made up of 2 components: the risk of not getting paid back and
the inconvenience for the lender of not having the money to hand. However, in a
barter economy it is easy to see that the inconvenience component could flip
the other way round: it might be more convenient for the lender to have the
goods at a later date than having them now. As in the coconut anecdote, both
men do not need surplus coconuts now, but to survive in the long term, they
will need them in the future when they are too old to climb a tree.
Hence it is feasible that in some
situations the convenience of receiving goods at a later date outweighs the
risk of not being paid pack. In such a scenario the lender would be ready to
accept to be repaid a smaller amount of goods than he loaned. This results in a
negative interest rate.
In the monetary economy
The same applies to the monetary economy.
Money was created to grease the wheels of trade and overcome physical
constraints of barter. Money is meant to be a means of storing value but it but
it does not quite achieve that perfectly for a number reasons. Because money is
a debt issued by trustworthy institutions (governments, large corporates etc),
its supply can over time grow and shrink independent of the available physical supply
of products and services. This causes fluctuations in pricing and inflation. Money,
therefore, adds a layer of noise over what is going on in the underlying physical
world. But noise is only short-term obfuscation, over the long-term market
forces will ensure that money reflects what is going on in the physical economy.
Productivity and Population
Positive rates of return on
investment (debt or equity) are only possible if there is an increase in
production over time. To increase production, you need either a growth in the
number of producers (ie people) or growth in productivity. As we saw in the
coconut example, the working population for the island was set to decline from
2 to 1. Unless coconut picking technology improves on the island, output will
decline and return on debt can only be negative.
Declining population
In many countries we are
witnessing population decline (Japan, Ukraine, Italy). Hence for output to
increase, productivity gains must outweigh population loss. The emergence of
negative interest rates in many of these countries is most probably a
manifestation that productivity growth is insufficient.
The chart below shows a
correlation, albeit weak, between a central bank’s interest rate and the national
fertility rate. It is interesting to note that all countries with a negative real
interest rate have a fertility rate well below replacement level. South Korea
does not appear to fit this pattern and is perhaps due a market correction?
If interests stay negative and
continue to decline, then we should be prepared to see average rates of return
on equity to follow into negative territory. The chart below compares the
annual yield of the S&P500 and annual US population growth since 1900.
The
correlation between the average yield and population growth is not easy to see
and is perhaps in the eye of the beholder, however it is clear that both
measures are experiencing a downward trend.
Why not hoard cash?
An obvious solution for savers to
avoid negative interest rates would be to hoard cash. The first problem with
this is that hoarding is not risk free: stuffing notes under the mattress is
not as safe as the bank. A hoarder will therefore need to spend funds on
security and storage to protect the cash pile. The second problem is that if
interest rates go low enough to make hoarding economically worthwhile then this
will quickly lead to a shortage of cash: everyone will seek to hoard the little
cash they possess, and governments will stop printing cash as the benefit of
interest free cash is reversed.
Impact on Company Valuation
How do negative interest rates
impact a company valuation? If the central bank rate is negative, then the cost
of capital for a company could potentially be zero or even negative as well. Any
analyst who has valued a company using a DCF (Discounted Cash Flow) methodology
knows that the lower the discount rate used, the higher the valuation, and that
a zero discount rate would value a company at infinity. A negative discount
rate would also lead to a valuation of infinity. A “negative interest rate
denier” would argue that this makes no sense: it is impossible for a company to
be worth an infinite amount of money therefore interest rates should never be
zero and definitely not negative.
The flaw in this argument is the
assumption that the DCF will give an infinite value. A DCF is composed of 2
components: a cash flow for a number of years usually 5 or 10 and a “Terminal Value”
which represents the value of the company beyond the 5 or 10 year projection.
It is the Terminal Value which could give an infinite value because it is
usually assumed that a company is an ongoing concern and will continue operating
ad-infinitum. This is a flawed assumption. All companies eventually fold.
Secondly, for the calculation of the terminal value, the analyst, using
textbook methodology, will assume either a constant zero or positive growth
rate for all eternity. This is the second flaw: in an economic environment
where you have negative interest rates, you should assume declining revenues
and correspondingly declining cash flows over time. With such assumptions you
will then get a finite valuation, even when using a negative discount rate.
Get data on UK companies: https://www.companydatashop.com
Negative interest rates will lead to bankruptcies and a rise in non-payment of invoices. See here for what to do about an unpaid invoice.
