With interest rates hovering at historically low levels across the globe, the question of who benefits from low interest rates and what unintended problems they can cause is once again on investor’s minds. For starters, debtors benefit which is perhaps why economies and governments around the world find themselves locked in the current low rate environment in the first place. However, low interest rates alone are not the answer to the current low growth environment. In reference to life’s roadblocks, my father always said, “if it was easy, everyone would do it.” This sentiment could be applied to interest rates because if the key to sustainable growth was simply having low interest rates then every country around the world would just have low interest rates and we would all grow to the moon.
But capitalism doesn’t work that way. In fact, for capitalism to work properly, capital itself has to have a cost that honors the needs of both savers (who supply capital) and businesses (which require capital). Savers seek an adequate return for supplying capital and businesses use the cost of capital as a measure to determine which projects should be funded and which should not. When interest rates are abnormally low, savers are inadequately rewarded for the risk they take, which can erode their willingness to share their hard earned treasure with the businesses that require it. This is detrimental to business expansion and formation which is not good for the long-term health of the economy. On the flipside, capitalism requires that businesses act rationally and make efficient capital allocation decisions by measuring and funding only the highest return opportunities. This relationship, which is built on the fundamental cost of capital, is a critical component to economic efficiency. In a period of extended low interest rates, however, projects that ordinarily would not be funded can receive funding due simply to low borrowing costs. On the surface, this can make certain projects appear economical, but in the long run these unwarranted projects can marginalize a company’s well-being as they lower overall margins and potentially lower long-term returns on shareholder capital. Moreover, low interest rates can cause companies to bypass capital reinvestment all together and focus instead on simply buying back their own stock with borrowed funds. In doing so, companies may be boosting earnings in the short run at the expense of long-term results by failing to reinvest as necessary in the business itself. Simply said, low interest rates can distort the historical relationship between risk and reward, suppliers of capital and consumers of capital.
In terms of future capital market returns, low interest rates have the effect of increasing present valuations on securities. Lower hurdle rates for return mean higher prices can be paid for securities. However, there is a limit to returns and ultimately there is a consequence to valuation expansion without commensurate earnings growth, and it comes in the form of diminished future returns. This is where we find ourselves today as the S&P 500 is trading at roughly 17x forward future earnings. This level is justifiable, in our opinion, given the current interest rate environment and lack of compelling alternatives. It does, however, present a predicament for investors in terms of future expected returns in a lower growth environment. The following chart illustrates the issue facing investors today.
It is important to distinguish between negative returns (which we are not forecasting) and positive but lower than historical average future returns (which we are forecasting). Our job of course, will be to maximize the opportunities that are available and deliver them on a risk appropriate basis. Nevertheless, we are nearing a point where monetary policy (low interest rates) is reaching the limits of its effectiveness and meaningful fiscal policy (tax reform, regulatory reforms and targeted infrastructure spending) is needed to potentially re-accelerate growth and reverse the potential of lower future expected returns on stocks and bonds.
Against this backdrop, what is an investor to do? The first thing all investors can do is to develop or revisit a concrete plan. Although markets are uncertain, everybody and every institution can develop a sound financial plan. You should know what you own in your portfolio and why you own it and develop a complete picture of your financial net worth. For example, what assets are liquid, which are not? How much do you need to save and how long do you have to work to amass sufficient assets for retirement if future returns are lower? What is your confidence score that if future returns are lower you won’t run out of money? Can you answer these questions? If not, it may be time for a sit down with one of our financial planning experts to analyze them. Whether you are an individual or institutional investor it is also a good time to focus on asset allocation. Should you take more long-only equity risk to offset potentially lower future returns? Should you position your portfolio in more conservative investments given less attractive risk/reward tradeoffs or are hedged strategies a better compliment to your portfolio at this point in the market cycle? The answer to any of these questions is not the same for any two investors. Individual circumstances can and will lead to different answers to many of these questions. We look forward to having discussions about these topics with you in the future.
John Micklitisch, CFA, CAIA, is the Chief Investment Officer at Ancora Advisors LLC a SEC Registered Investment Advisor.
The mention of specific securities, types of securities and/or investment strategies in this newsletter should not be considered as an offer to sell or a solicitation to purchase any specific securities or to implement an investment strategy. Please consult with an Ancora Investment Professional on how the purchase or sale of specific securities can be implemented to meet your particular investment objectives, goals, and risk tolerances. Past performance of these types of investments is not indicative of future results and does not guarantee dividends/interest will be paid or paid at the same rate in the future. The data presented has been obtained from sources that are believed to be accurate and credible. Ancora Advisors makes no guarantee to the complete accuracy of this information. The indexes discussed are market performance indices and are not available for purchase. If you were to purchase the securities that make up these indices, your returns would be lower once fees and/or
commissions are deducted. Past performance of these indices is not indicative of future results of the securities contained in these indices.
Ancora Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States. A more detailed description of the company, its management, and practices are contained in its “Firm Brochure” Form ADV, Part 2a. A copy of this form may be received by contacting the company at: 6060 Parkland Blvd, Suite 200, Cleveland, Ohio 44124, Phone: 216-825-4000, or by visiting our website www.ancora.net/adv