ZIRP, NIRP and The TINA Effect
2016 has so far produced overall company sales and earnings struggling under the weight of tremendous debt levels in a sluggish global economy. It has now been five quarters in a row where earnings have declined, so we are in an earnings recession. How is it that the stock market is then trading near its all time highs? Low interest rates, even zero (ZIRP) and negative (NIRP) in some cases, coupled with the fact that There Is No Alternative (TINA). If you have savings (retirees, pension funds) and want income, given over half of the world’s bonds ($12.6 trillion to be exact) are now paying negative rates, you are forced to look to stocks and dividend yields, despite the increased risk of potential loss of capital.
Interest rates are always the most important element of finance. The second most important variable is inflation. Interest rates and inflation are influenced by the Central Bank with the objective of achieving price stability (inflation target is around 2%), while providing a policy encouraging employment growth. The central banks control what price banks can borrow at, and this in turn sets interest rates for the general public.
Interest rates pretty much set the price of fixed income securities such as treasury bills (t-bills) and bonds, as well as stocks. Treasury bills are guaranteed by the government so whatever yield they provide is considered the “risk free” rate because governments can always pay back their debt (through higher taxes or by just printing more money). This is therefore, the most important rate to look at when investing in capital markets.
The price of a bond is inversely related to that of interest rates, meaning a fall in interest rates leads to a rise in bond prices (and a lower bond yield). So after 35 years of declining interest rates, bonds have enjoyed a sustained period of outperformance as bond prices have soared.
This bond outperformance continues to be extended today as a result of unprecedented accommodative Central Bank polices from around the globe resulting in global government bonds carrying either zero coupon rates (ZIRP) or even a negative yield (NIRP) – the first time in history. This means investors are guaranteed to receive less money in the future, if they hold the bond until maturity.
Investors today are therefore not buying bonds for the yield, but for the price appreciation, implying that they hope interest rates will go down and the price of the bond will go up. However, any change in interest rates to the upside will have these bonds come crashing down as fast as they went up – recall the inverse relationship between the price of a bond and interest rates. Given rates are now negative or pretty close to zero, there is a much higher risk that they will be going up (even marginally) rather than down.
Today’s ultra low bond yields are a major concern with serious ramifications. For one, pension funds and insurance companies are typically mandated to hold a defined fixed income weighting. Historically, owning fixed income instruments provided enough yield to satisfy their obligations on pension funds and insurance products – something impossible to do with negative rates.
An important function of interest rates is the fact that it determines the amount of income paid to those living off their pensions and other investments. When this level is not enough, investors will seek to invest in whatever instrument offers the highest yield for the same level of risk but with negative rates investors desperate for income are ignoring the risks. This is also known as “reaching for yield”.
If income is a top priority you may opt for dividend yields on stocks at 2.3% instead of 1.5% on a t-bill, but if interest rates go up, the stock market goes down to reflect the new discount rate on cash flows, and the capital loss will be much greater than any potential income you could get over time. Meanwhile if you invest in a treasury bill, the price of it will also go down with an increase in interest rates but, as long as you hold it to maturity, you always get your capital back – so is investing in something that yields 2.3% versus 1.5% worth the potential risk of capital loss?
If it is a permanent loss this is a bad investment decision. You must be assured that a) the dividend is safe and b) any capital loss on the stock will be short term because you did not pay a multiple for it that was justified by abnormally low interest rates. The excess yield on the S&P 500 over U.S. Treasuries is because the S&P 500 is a more risky investment option. As investors “reach for yield” they are assuming that these riskier investments provide (and can be counted on to provide) higher returns. However, if riskier investments reliably provide higher returns they are by definition not risky.
So how else do (bond) yields influence the stock market? Well interest rates are also used to price stock prices. Future company earnings/cash flows are discounted at the risk free rate (government bond) plus the equity risk premium (usually 3-6% depending on how risky the business is) that one demands for owning a stock over a bond and holding it to maturity. Therefore the higher the rate used, the lower the stock price should be and vice versa.
Furthermore, the appropriate price to earnings multiple that the market should be trading at is also determined by the interest rate – for example if interest rates are at 5%, then the stock market should be trading at around 20x earnings (1 divided by 5%) – if interest rates are at 2% then theoretically the multiple could go to 50x. Given interest rates are so low, and likely to remain low, even if there is a rate hike or two coming up, the market could theoretically keep rising until it reaches that multiple that puts it in line with the interest rate on a bond – with negative interest rates that multiple could technically be infinite (This is how bubbles are created).
Investors have recently been willing to pay a big premium for stocks offering a high current yield (utility and telecom companies come to mind). Big yields can be very misleading as it may be a result of a depressed stock price (where the price of the stock is low for a specific fundamental reason such as deteriorating fundamentals or a bad balance sheet and ultimately that dividend will be cut). The force of investors piling into the high dividend yielding stocks has been so strong that these stocks have now reached extraordinary valuation levels. This cannot be sustained and will be reversed violently the minute there is even the thought that a rate rise could be imminent.
As investors “reach for yield” they are giving very little thought to the incremental risk that they are taking on as a result and definitely aren’t demanding compensation for it.
Overall today it is tough to get excited about the total return profile that the market has to offer: earnings recession, low growth, depressed dividend yields and little room for further multiple expansion. Nevertheless, as long as rates stay low, the melt up of the markets will continue because there is just no better alternative and people need income to live.
The Summerhill Team.