by Ryan W. Smith
In March 2016, the Federal Reserve asked big banks to begin looking at the potential impact negative interest rates would have for stress tests. While this practice of paying money to a bank to hold money is very new, it has already been implemented in certain areas of the world, namely Japan and Europe. The concept, however, is still so new that unintended consequences are only now being uncovered.
This is the third and final article of a three-part series exploring Negative Interest Rates and their potential impact.
When the Federal Reserve backed off its four-hikes in 2016 approach following its January meeting, many analysts were not surprised. However, when the Fed then held rates steady again in March, April, June and July, many openly wondered if the possibility of a recession and, eventually, the need for negative interest rates in the United States were increasing. After all, if rates are near-zero and need to be relaxed to fight a recession, where else can they go?
Many industry analysts began wondering about the likelihood of a negative interest rate policy even as Federal Reserve members spoke loudly against the need for it. It is, therefore, widely acknowledged that the risk of negative interest rates in U.S. still remains relatively low. However, it is not completely impossible to imagine a scenario where they might be deemed necessary.
Indeed, with the recent request from the Fed to American banks to look at their potential impact on stress tests, it is apparent the Fed has imagined these scenarios as well and wants to keep options open. Therefore, it is prudent to look at areas that might be influenced by negative rates, if implemented in the U.S.
Corporate earnings are softening while GDP is increasing at only a 1.5% annual rate. Growth is difficult to come by organically, so mergers and acquisition activity is rising in general, but not all sectors are increasing. In the absence of M&A activity, many companies are buying their own stocks back to show earnings growth per share.
One way to see this rise in buybacks is by looking at the price-to-earnings ratio for the S&P 500 as a whole. A steadily, but slowly, rising price-to-equity ratio often shows a stock market that is range-bound or slowly rising as corporate earnings decline or hold steady. Since hitting a 25-year low in late 2010, the P/E ratio for the S&P 500 has been showing these signs, growing slowly and steadily.
During the past 3-4 months the P/E ratio for the overall S&P 500 has increased at a quicker pace. After staying in a range between 23.5 and 24.5 for about 18 months, the P/E ratio broke thorough that range and continued higher. With its most recent reading at 25.25* as of August 22, 2016, up from 23.94* only two months prior (June 17, 2016). The only periods in the 140 year history of the S&P 500 that havew had higher readings for any length of time were briefly just before the 1896 Presidential Election, the tech boom of the late 1990s and early 2000s and the global recession from 2008-2009.
This steadily rising P/E ratio, for six straight years, is evidence of increased stock buybacks by companies. Corporations spent 54% of their overall profits on buybacks during the last decade, according to a 2014 Harvard Business Review study of corporate profits between 2003 and 2012. The study also showed that 37% of earnings were used for dividends during the same 10 year period.
In a negative interest rate environment, with a slowly expanding economy, stock buybacks are likely to continue and perhaps even increase. With interest rates so low, even taking on debt to finance additional buybacks would be hard to ignore for executives with stock options built into their compensation packages. This would slowly increase stock prices because of fewer shares available for trading in steady economic conditions, but eventually the piper’s melody would fall out of tune.
Only so many shares of a stock can be repurchased before the market would view as security as “illiquid” on a macroeconomic level. If the idea is to increase the stock price through buybacks but the market suddenly decides that the most important variable needs to be increasing top-line growth, have companies invested enough in maintaining their market share, product quality and maintenance costs? Have they continued to properly invest in research and development to build and design new products?
If not, markets will hit the reset button and a decline in the indices would be necessary, most likely a correction but perhaps more. When investors conclude that future growth cannot keep up with the level of current market multiples, most shown notably by the index-wide price-to-equity ratio for the S&P 500, recessions, bear markets and in some cases, market crashes, will occur.
Stressing the Bonds
Negative interest rates would most likely wreck havoc on bond investing throughout structured finance markets, also referred to as the debt market. Bond interest provides the lifeblood of the world economy, providing a safe, long-term haven for capital preservation strategists with large accounts. Pension funds, for example, are reliant on earned interest to maintain necessary funding levels and account for inflation. In a negative interest rate environment, they would be forced to purchase lower-quality bonds to get the same return as they would in a more normal environment. Currently, Germany is starting to see this as recent rates for the Bund have dropped to zero and German investors are looking to more risky offerings.
If a negative interest rate environment were to persist for long enough, the economic dangers would be serious. In the U.S., retirement doles are increasing by 10,000 per day and the long-term ability to maintain future claims crumble as investment returns wouldn’t keep up with pay-out growth.
Insurance companies would also be in trouble. Any liabilities marked-to-market would necessarily be more expensive to resolve, with those additional costs causing a drop in capital levels and creating a wrinkle in the stress test. This could be the underlying concern the Federal Reserve wants to resolve by having banks add negative interest rates to their stress tests.
Most large banks have insurance divisions and would, likewise, need to factor in higher liability maintenance costs and rising default rates that would likely occur in a negative interest rate environment when conducting their continuing financial stress tests.
Structured Finance, the debt market, was where the 2008 global recession began. As debtors took on more debt than they could handle, the number of defaults increased. This occurred at both the individual level, specifically mortgages, and in the corporate market, specifically derivative debt insurance tied to mortgage-based securities. Once too many debtors defaulted, the remaining spliced up interest payments were not enough to sustain credit derivatives and the debt market fell like a house of cards.
Another very useful economic number is the credit spread, which looks at the difference between government bond interest rates and corporate bond interest rates. If credit spreads are tight, then investors see little risk between strong corporate bonds and U.S. Treasuries. The larger the number, however, the greater the risk of an economic downturn, with continuing large numbers often pointing towards recession. Currently the credit spread is at its highest level since 2008. This spread would significantly widen under a negative interest regime, which would increase the cost of obtaining capital despite the lower interest rates.
For now, it is very difficult to determine the exact outcome most likely to occur if the United States implements a negative interest rate policy. Thanks to Europe and Japan, we have the beginnings of a decent idea of what areas will be impacted, but the results have not been consistent thus far. It does appear, however, that the age of negative interest rates is upon us in some form or another.
Evidence continues to mount and the possibility of negative rates washing up on our shores will remain for quite some time.
* source: Standard & Poor’s, as shown on http://www.multpl.com/