In recent months, several of the world’s central banks have conducted a highly risky experimentwith negative interest rates.   For example, the Bank of Japan has a rate of minus 0.1%, the European Central Bank has a deposit rate of minus 0.4%,  and Switzerland’s bank rate is a minus 0.75%.  German government bonds with maturities as long as seven years, and Japanese government bonds with maturities as long as ten years are now trading at negative yields.

“What!” you say?  Do you mean to tell me that I won’t receive interest, I will pay interest? Say it isn’t so!”

Sadly, although “Shoeless Joe” Jackson was acquitted of throwing the 1919 World Series to the Cincinnati Reds, the Central Banks are guilty of taking money from savers and throwing it to the borrowers.

The traditional methods of curtailing debt and stimulating economies have failed.  First came low-interest rates, then zero interest rates,  then quantitative easing  (in all its iterations).  Just as these gambits failed to gain traction,  the negative interest rate experiment is also likely to be ineffective in my opinion.  Ham-handed central bank intervention in otherwise free economies invariably leads to inefficient allocation of capital,  distorted risk-reward motivations, and price instability of securities.

One obvious result of negative interest rates is that depositors may withdraw their money from bank accounts and bonds and stuff it under the mattress. However, we are not seeing runs on the banks in the countries in which negative rates are already the reality.  It appears that depositors will pay a small price for the convenience and security of a bank account to store currency.  I am sure there is a limit to the amount they will pay, however.  At some point,  if rates go too negative,  depositors will withdraw their funds and store it in their vault at home or in a safety deposit box.  The exception to this would be if we were to enter a deflationary environment in which currency would appreciate in real terms,  perhaps even after a negative rate is assessed.

The other possible destination of the currency is equities,  which will look better in comparison to cash and bonds that are encumbered with negative rates.   In laymen’s terms:  You will be more likely to invest in stocks instead of cash and bonds if you know that cash and bonds will result in a guaranteed loss.   This would drive up equity valuations, benefiting current owners of equities.   That higher valuation would likely result in lower subsequent equity returns over the longer term, however.

In recent months, inflation expectations in the US have risen above the Fed target of 2%.  For that reason, I see a low probability of negative interest rates here in America over the short term.  At least for this business cycle, it appears that the Fed’s zero interest rate policy from 2008 through 2015 was sufficient to stimulate demand.  As for the next recession,  all bets are off.  With each successive business cycle, the Fed’s prescription has been ever stronger medicine. The next dose may well be negative interest rates.

These observations are not meant to be translated into a market forecast.  (You know our philosophy better than that!)  Future market prices and interest rates are not predictable.  Period, end of story.

As always,  our advice is to stay with your plan:  A sensible, consistent equity exposure that is likely to continue to be beneficial over a long time frame;  a common sense approach designed to control risk and maximize the likelihood that your goals will be achieved.

 

A Few Market Observations

This year, the US stock market has already seen the worst January in history, followed by a March that was so positive that we are now in the black in 2016.  With all of this short-term volatility, it is easy to lose sight of what has happened historically over very long time frames.

Over the past fifty years from 1966 through 2015,  the annualized return has been 9.69%.  Lest you think that those results were unusually good,  consider that the previous fifty year period from 1916 through 1965 had a return of 10.36%, and the fifty years before that from 1871 through 2015 had a return of 9.05%.

However,  over some long time periods, the results were less favorable.  For example,  in the fifteen year time period between 1966 and 1981,  the market return was 5.89%,  and after the very high inflation rate at the time,  the real return was a negative 1.04%.  In more recent memory we can point to the “lost decade” between 2000 and 2009, where even the nominal return was negative.

I am not implying a forecast for the future but simply pointing out that the rewards of long-term investing come with declines, and these slumps can last for a long time.  Just don’t fall into the trap of believing that anyone knows when the next slump is coming, or how long it will last.

Read the Spring 2016 Newsletter Here

James Twining
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