What negative interest rates mean for investors

 

The tepid recovery from the Great Recession aggravated by market volatility in financial and commodities markets, has spurred calls for negative interest rates as a policy tool. Negative interest rates can be implemented by charging banks that hold excess cash deposits at central banks.

In theory, this would encourage banks to move from sitting on cash to loaning it out, which ought to lead to more consumer and business spending. In this regard, the mechanism by which negative interest rates might impact the economy is no different than how a cut in interest rates from two to one percent ought to stimulate the economy. But what often gets lost in this discussion is what happens to the average investor and the outcome isn’t pretty.

Falling interest rates should increase stock prices and low rates over the past few years has boosted equities. That’s because when rates drop, investors have to buy stocks, usually high-yielding ones, to make any money. However, that’s not what’s happened in regions that have already gone negative.

In June 2014, the European Central Bank’s deposit rate was cut to –0.1 percent. Since then, the iShares MSCI EMU Index ETF, a security that tracks an index composed of large and mid-cap companies located in euro zone countries, is down nearly 30 percent.

Switzerland imposed negative rates in December 2014, the iShares MSCI Switzerland Index ETF has fallen by about 14 percent. Sweden entered minus territory in February 2015, and its market has dropped by 20 percent. The only market to see a gain since introducing negative rates is Denmark, with the iShares MSCI Denmark Capped ETF up 94 percent since July 2012.

Of course, the U.S. is far larger than many of these markets, so what happens there may not happen in the U.S. markets. Why? A big reason is that negative rates do not instill confidence in the economy. If people are nervous, they won’t borrow and spend.

Negative interest rates can make people think the economy is tanking, they may just keep their money safe in a bank account instead of spending it on goods and services. The mere talk of negative rates could discourage businesses and consumer from spending as much as they normally would. If they do hoard cash, then company earnings would fall, taking their stock price down with them.

The danger of negative interest rates

It’s unlikely that financial institutions will make people pay for storing money in an account unless they want to risk a run on the bank. However, banks could increase fees for other services to help offset what they have paid to store their money at a central bank. Plus, the banks will earn less money and therefore have less capital to make loans.

Another problem is that low rates have already made stocks more expensive than their historical average, which means that equities as an alternative to bonds isn’t as attractive as it once was. Sure, someone can still get good dividend payouts, but they’re now paying more for those companies.

For example, Procter & Gamble has a dividend yield of 3.27% and trades at a forward price to earnings ratio of 20 times. However, their earnings are only growing at less than 5% per year. The six month chart below illustrates how investors are being pushed up the risk scale searching for yield.

I believe that the rise in the stock market has a lot to do with share buybacks. If borrowing costs get low enough, more companies will simply issue debt and use that money to buy stocks. This is attractive for dividend-paying companies, who would then only pay dividends on a fewer number of outstanding stocks.

Savers are also at a big disadvantage in a negative-rate environment. It’s hard enough to make money in a savings account today, but if rates are effectively zero, then it will be impossible to generate any return on cash. That means young people just won’t be able to save enough to buy a car or purchase their first house.

We are navigating waters that we have never traveled on before. You might think that it would be stupid to say “cash is king,” but cash is king when your other option is taking on too much risk in the markets and where there’s no academic theory on what happens when rates go negative.

 

 

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