First Eagle Investment Management December 2015 commentary, titled. “Navigating The Current Rate Environment.”
Low interest rates globally have been an important driver of asset price returns over the past few years and are very much on investors’ minds today. In our conversations with financial advisers, many questions come up: How long can we expect the low-rate environment to continue? What has led rates to be so low in the first place? What are the consequences of global central banks’ quantitative easing (“QE”) policies? Have we definitively slain the specter of inflation?
Giorgio Caputo, one of the portfolio managers of the First Eagle Global Income Builder Fund, shares his thoughts on today’s low-interest-rate environment and how it’s impacting asset prices and the search for value and income.
Q: How do the upcoming Federal Reserve meeting and the possibility that US short-term interest rates may finally lift off from zero affect your outlook?
At the risk of some hyperbole, this may very well be the most discussed potential 25 basis point move in the history of money. At First Eagle, we respect the view of the Austrian School of economics that bad things can happen when money is free. When we invest in risk assets, we try to look across business cycles to discern what we believe is the reasonable, mid-cycle intrinsic value of an asset. As a result, we haven’t lowered our underwriting criteria in response to the current low-rate environment.
By keeping rates at zero for so long, the Fed, in our view, has attempted to dampen the business cycle and has potentially distorted pricing within certain asset classes (particularly those that are rate sensitive). This has made it harder for investors to generate income with a “margin of safety.”1 The Fed’s efforts may even have been counterproductive. In the case of aging economies, there is some evidence that low rates can actually reduce consumption, as retirees and near-retirees feel the need to save even more to compensate for low yields on existing savings. For these and other reasons, we would welcome a normalization of money rates.
With that said, there remain a number of deflationary pressures throughout the world, such as the strength of the US dollar and the “collapse” of commodity prices. One of the largest deflationary forces may stem from remarkable developments in China, as it attempts to transition its economy from its current fixed-asset-intensive phase to a more consumption-oriented model. However, in the process of growing by fixed-asset investment, China has built up vast industrial capacity for everything from steel and copper production to automobiles, machinery, etc. The output of these businesses, some of which continue to be subsidized in various ways by the state, has to find a home and, as a result, is depressing prices globally. In assessing whether or how fast to raise rates in the future, the Federal Reserve will certainly need to consider the deflation stemming from China and other sources.
Q: What has caused interest rates to be so low for so long?
There are always a broad number of factors that impact interest rates, but in recent years it seems primarily that the combination of quantitative easing and the fear of deflation, coupled with lower potential economic growth, have led both central banks and investors to generally drive up bond prices. Even with the QE taper complete in the United States, sovereign purchases by other central banks feed back into US bond yields as investors scour the world for income. Similarly, the strong performance of the US dollar may likely lead to increased flows into the United States, which often end up in the Treasury curve because of the depth and liquidity of that market. Additionally, a flight to perceived safety prompted by geopolitical concerns further enhances inflows to US assets. Lastly, it is important to point out that global debt levels have not fallen materially. The modest declines in financial leverage seen in the US have been largely offset by increases in debt levels in China and other geographies. These high debt levels can amplify the deflationary pressures and fears described above.
What is clear is that those investing in long-term debt at the current low yields are making the assumption that it will be very difficult for rates to return to normal levels for a number of years. Based on interest-rate forward markets, one has to go almost 10 years into the future before 10-year US bond yields cross 3%.
Q: How have low rates impacted asset prices and investment?
The impact on asset prices has been pronounced, with rate-sensitive asset classes being among the best performers in recent years. Beyond this—and perhaps more importantly—the level of rates sets the discount rate at which investors convert future cash flows to present values. In this fashion, low rates can potentially drive higher asset values across all capital markets. Put differently, since all assets have to compete for capital, when a large asset class such as developed market sovereign debt yields so little, this competition for capital becomes much easier, leading investors to pay up for riskier alternatives (which is the point of the QE programs).
One of the negative consequences of artificially suppressed interest rates is the risk of mal-investment. Following a binge of credit issuance, master limited partnership (MLP) structures and yield-linked derivatives, it is hard to argue that some mal-investment hasn’t taken place. These financial maneuvers are linked to the real economy, as capital has been expended to create and sell the income properties, transportation infrastructure, pipelines and energy production through these financial vehicles. Somewhat less directly, high asset prices improve confidence and collateral values, and perhaps drive some undesirable consumption as people feel wealthier.
While many investors view low rates as a rationale for high equity valuations, at First Eagle we ask ourselves if the opposite might not be true. If rates are forced to be low (even negative!) due to the fragility of the global economy, should this not be viewed as sign of vulnerability and perhaps a reason why multiples should be lower than historical norms?
Q: Is inflation dead?
We certainly don’t think so, but inflation has had a long period of hibernation. To some extent, the US Fed has continued to live off the inflation-fighting credibility it gained during the Volcker chairmanship and the early portions of Greenspan’s tenure. It has been central bank orthodoxy since then that inflation must be kept under control. The European Central Bank and Bank of Japan, which don’t have the same historical credibility, have faced greater challenges meeting inflation targets.
Milton Friedman famously stated, “Inflation is everywhere and anywhere a monetary phenomenon.” The risk we see potentially unfolding over the next decade is that central banks, in their inability to combat deflation, resort to printing ever increasing amounts of currency and that markets begin to lose faith in the effectiveness of central banks (and potentially even in the value of the currency). The relentless growth of a monetary base is hard to overcome in the long run. Historically, even gold-standard economies witnessed inflation when the supply of gold increased rapidly. These abrupt discontinuities can be a while in the making before the paradigm suddenly shifts and inflation expectations become unhinged. In order to understand Friedman’s assertion of the true power