Your Quarterly E-Zine
Edition 11 • December 2019

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Zero hour

Following a surprise 50 basis point cut to the official cash rate (OCR), from 1.5% to 1.0% in August, the Governor of the Reserve Bank of New Zealand (RBNZ) commented that it is not inconceivable that we will see negative interest rates in New Zealand in the future.

The Governor’s words, which came as a shock at the time, need to be considered in the context of global trends. Unconventional monetary policies, since the Global Financial Crisis (GFC), have become the norm. While initially viewed as temporary to enable the global economy to recover, and encourage growth through investment and risk-taking (i.e. capitalism), unconventional monetary support now looks to be permanent.

Economic growth has recovered, albeit at lower rates, but the broad measure of inflation (as measured by consumption items) has failed to rise to, and above, the Central Bank targets of 2.0%. The beneficiary of all this unconventional policy has been owners of assets, both financial and real, as asset price inflation has soared.

Since 2008, the combined size of the Central Bank balance sheets from Europe (ECB), Japan (BOJ), China (PBoC), and the United States (Federal Reserve) has surged from US$6.3 trillion to US$19.4 trillion. All this money printing has been used to buy bonds from each Central Bank’s respective market, essentially monetising the debts of their economies.

All this money has to find a home. If it is not being used to invest in plant and other capital stock, increasing the productive potential, or in housing and infrastructure, it usually finds its way to financial assets due to their higher returns.

As Central Banks lowered their official cash rates to zero and below, the surplus cash flowed around the globe, seeking out higher yields. This globalisation of financial assets has resulted in global bond yields converging towards the lowest returns, which are now negative.

It is estimated that 30% of the global government bond market is now trading in negative territory. In Denmark, consumers can now take out a 10-year mortgage with a negative mortgage rate. Effectively, the Danish banks are now paying their customers to borrow money. Why? Because the current fear is that interest rates fall even further. This is the danger of deflation. Switzerland’s entire bond curve is now trading with negative yields.

The world economy is still repairing itself from the effects of the GFC. The debt crisis in the United States housing market that cascaded into banks and other financial institutions around the world was the result of three decades of excess borrowing and liberalised financial markets. The US consumer had become the global consumer of last resort (otherwise known as the United States trade deficit). When workers in the United States lost their jobs and homes in 2008, their wallets slammed shut, and the global economy suffered. To recover from the crisis, Central Banks responded by issuing increasingly higher levels of debt, but at lower and lower interest rates.

As trend rates of global growth continued to drop, higher debt levels have become a burden that ageing and shrinking workforces are struggling to service, let alone repay.

Zero or lower interest rates pose challenges for most investors. For the banking sector, this is a worst-case scenario, with banks relying on core funding derived from deposits. These deposits are then lent out to customers with a margin based on the shape of the yield curve. In normal markets, investors demand a higher yield for longer-term investments, as a hedge against inflation and liquidity. For banks, their profit margin has historically been derived from borrowing short, at low rates, and lending long, at higher rates. A flat or inverted yield curve suppresses bank margins making traditional lending less profitable. The result could be substantially less appetite, and ability by banks to lend to domestic borrowers.

Credit risks also increase in a low rate environment. In a normal functioning capitalist economy, weak companies are allowed to fail - either from being taken over by stronger competitors or closed down so the capital used can be deployed more effectively elsewhere. Today, these “zombie” companies are allowed to continue operating as they can refinance very cheaply. Their continued operation squeezes the profits of more competitive companies, degrading the overall productivity and lowering potential growth.

Assets with reliable and positive coupons such as high-grade bonds and some equities (sustainable dividends) will continue to benefit in this environment. Infrastructure, utilities and quality commercial property are examples in the equity sector. Real assets such as real estate (bricks and mortar), gold, art, and wine will also attract cash looking for a home rather than being left in the bank and losing value.

While our central scenario is not to expect negative interest rates in New Zealand soon, the global trend indicates that clients should be considering the possibility and planning accordingly. The first thing to consider is the appropriateness of your investment guidelines. These may need to be reviewed to broaden the investable ranges for bonds and certain equities, as well as the potential to consider alternative asset classes such as gold and other real assets.

Kevin Stirrat
Director/Strategy, Wealth Management Research

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