What a weird world. While President Trump heralds the bigliest strongest US economy of all time he is at the same time demanding the Fed lowers interest rates to support this very same ‘super’ economy. Colour me orange but that’s not really how it’s supposed to work. Then again quite a few things are broken right now.
Take your pick from the following recent events in the financial markets:
- Currently there are $14 trillion worth of government bonds trading with negative yields ie borrowers are being paid by the lenders to borrow.
- Nordea Bank in Denmark has just started offering 20 year fixed rate mortgages which charge no interest.
- UBS in Zurich has just told its super-rich clients it will now charge 0.6% per annum on cash savings of more than €500,000. Yep, the new way to save is to shrink capital…
- Beyond Meat the non-meat burger company with just under 400 employees listed publicly a few months ago via IPO. Its current market value of $13 billion recently exceeded that of Molson Coors with 18,000 employees and a 233-year history in brewing beer.
- Shipmaker Harland & Wolff and retailer Barneys face final closure after many painful years of battling structural change.
The above events might strike you as a random list but there is a common thread running through each of these developments. Central banks across the globe are reversing course and creating a financial environment where borrowing costs are ultra-low or even negative. The aim of this article is not to explore the drivers of this phenomenon but rather highlight the implications for business owners and investors if money was to remain effectively free for a prolonged period of time. We thought of five key implications:
- Capital Flows:
- Business Valuations:
- Banking Pain:
- Competition:
- Zombies:
A key fear of central banks is deflation so the purpose of removing incentives to deposit money is to force savers to put money to work in the economy via direct investment or spending/consumption. So, if capital is redirected there is potentially a much greater opportunity for young businesses to access growth capital.
Low-interest rates also have another nice benefit for those seeking equity funding of their businesses. Most valuation methodologies will seek to discount the future cash flows of business back to the present to generate a present/current value. As part of this calculation, an interest rate is used to account for the time value of cash flows/profits due in the future. Lower interest rates boost the present value of those cash flows and increase the value of the equity in these businesses.
Clearly borrowers are helped by lower interest rates. But, banks will struggle in this kind of environment. Think retailers and the loss of pricing power and you will understand the pressures on banking franchises already struggling with the digital transition, increased competition and regulatory costs. It is no surprise these days to read frequent reports of banks struggling to generate decent returns for shareholders and share prices experiencing dramatic declines in relatively strong equity markets.
For existing businesses there is a drawback associated with almost free capital. New competitors can start up very quickly and attack market shares with loss-making strategies funded by cheap and returns-starved capital.
The references to very old franchises like Harland & Wolff and Barneys above also highlights another negative for the healthy functioning of capitalism. Struggling franchises (aka Zombies) availing of very low-interest rates can stay in business far longer than would have been normally the case. This tends to depress investment and economic growth – just ask Japan how low rates have worked over the past 30 years. It also raises the risks of a far more damaging wealth destruction event in the future if interest rates were suddenly to rise.
It is probably best to think about negative rates as a short-term fix in an increasingly toxic and populist political environment. We are currently seeing capital chasing increasingly scarce yield to earn a return and ignoring valuation risks. However, history would suggest the long-run outcome of that strategy is significant and permanent capital destruction. On the flip side of this risk warning, the good news is that great business ideas and start-ups will get funding and with the arrival of equity crowdfunding platforms the small investor can access these opportunities before the big institutions start to seek alternative homes for their capital. See our previous article “Use It or Lose It” for a reminder as to why timing is on the side of smaller investors this time!
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