Negative Interest Rates and Deflation

We discuss the growing trend of negative interest rates.

In recent decades, negative interest rates have been a rare thing and for good reason. Why would anyone be willing to pay for the privilege of lending someone else their money?  But as hard as it is to believe, this is exactly what’s becoming increasingly common globally, in stark contrast to previous experiences. So why does this happen?

Typically, central banks reduce interest rates to low levels because they either want to encourage borrowing by domestic consumers and enterprises (to help boost consumption and investment), or they want to weaken their currency to improve the competiveness of their exports. Recently, however, we seem to have entered a new era where negative has become the new low.

Negative is the new low

Yields on various short- and medium-term government bonds have been negative for some time. But the phenomenon isn't limited to low risk government bonds: earlier this year the yield on Nestlé’s 2016 corporate bond dipped into negative territory and several Continental European banks introduced negative rates on some deposits.

The other side of the coin

Looking back over recent history, deflation (the fall in consumer prices over a period of time), is an equally rare beast. But in the post-2008 world, low or negative interest rates and deflationary forces have become two sides of the same coin.

Macroeconomists generally agree inflation and deflation are monetary creatures. However, in the short run, many factors can push an economy towards deflation, the recent decline in oil prices being a good example.

There is also substantial evidence that deflation is a direct function of an economy's credit growth minus growth in its real productive potential. So if credit grows more slowly than growth in productive potential, the demand for goods and services will slow and prices will have to fall to sustain demand. Obviously the opposite holds true as well, so as credit growth picks up the structural deflationary pressures start to disappear.

In the early 1930s changing consumer prices led to a dramatic decline in economic activity – post the Lehman bankruptcy central bankers, desperate to avoid another 30s style depression, made  massive injections of liquidity into the global financial system, famously labelled "quantitative easing". This move was designed to maintain the quality and frequency of economic transactions and return wages, corporate profits and rents to a path of growth.

In recent years, banks in many countries have deleveraged and become generally more stable. Bank lending has strengthened as a channel for global liquidity, alongside persistently high volumes of global bond market issuance. The historical pattern where low levels of volatility coincide with rapid growth of cross-border banking activity may be starting to reassert itself.

To facilitate continued growth in employment, consumer expenditure and business investment, ever more creative measures have been applied by public institutions globally. As innovative as they are in comparison with traditional programs supporting economic expansion, their outcome is by definition uncertain.

It is still early days in terms of being able to assess individual successes. Quantitative easing certainly helped in the early stages of the recovery from 2009. The concerted weakening of several major currencies almost certainly didn't. The bottom line is we need not fear deflation as long as economic growth continues, even if it is only at a minuscule rate.

Deflation investing

Although the current environment is fairly unique in the history of financial markets, we can still draw some lessons for investments from previous periods of deflation.

Real returns are defined as annual capital gains and income (such as dividends for equities and interest for bonds) minus the change in consumer price levels. This approach gives us the right yardstick for comparing capital maintenance and return over periods of deflation, price stability and inflation.

Research by Credit Suisse (Global Returns Yearbook 2012) into bond and equity returns between 1900 and 2011 shows equities delivered a real annual return of 11.2% during periods of distinct deflation - significantly lower than the real 20.2% return on bonds. Over all other periods, however, equities brought on average 5% better returns than bonds. Interestingly and perhaps surprisingly for investors, during periods of severe deflation, real equity returns were only a little lower than at times of slight deflation or stable prices.

For investors concerned about the purchasing power of their investments, a natural alternative to publicly traded assets is to hold property. London Business School research covering 18 OECD (Organisation for Economic Co-Operation and Development) countries shows real house-price changes are relatively insensitive to inflation. However, in reality most investors will never be in a position to build a truly diversified property portfolio and for the majority, the most common way to hold property is to own their own home.

This list of assets - cash, equities, bonds and property - is far from exhaustive and there are numerous articles that discuss other options such as private equity, commodity-linked derivatives, and others. Since reliable data for these asset classes has only become available during the past 20 years, it is too early to be able to draw reliable conclusions as to the real opportunities these could offer long-term investors.

Conclusions for investors

The current era of low to negative interest rates and the persistence of deflationary forces have created new challenges for investments.

Investment policies and strategic asset allocations need to incorporate the personal circumstances of investors and a new relationship between consumer price changes and interest rates.

For the remainder of the present financial markets regime, risk controlled equity portfolios with potentially high dividend paying stocks are the preferred engine of a diversified income investment strategy.

Important information

Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise.

No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed herein.

Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions.

Any views expressed within this report are our in house views as at 6th March 2015 and should not be relied upon as fact and could be proved wrong.

The information contained in this webpage has been derived from sources which we consider to be reasonable and appropriate.

This content may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent.

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