The Broyhill Asset Managment Letter for the month of August 2016 on “What Happens When Interest Rates Fall Below Zero.”
Also see top hedge fund letters
If I had a world of my own, everything would be nonsense. Nothing would be what it is, because everything would be what it isn’t.” – Alice’s Adventures in Wonderland, Lewis Carroll
August 16, 2016
In A Short History of Financial Euphoria, John Kenneth Galbraith speculated that financial memory should last a maximum of twenty years. “This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius.”
Twenty years is a long time. It is a particularly long time for the attention span of today’s investors who are challenged to hold onto investments from quarter to quarter. So perhaps it should not come as a surprise that we have already experienced two financial disasters in the past twenty years. And already, a new generation of investors has entered the scene. The “innovative genius” of zero percent interest rates has allowed economic amnesia to set in quicker than ever. Financial disaster has been erased from financial memories. In its place is a parallel universe where zero interest rates justify any price. Weird stuff happens when interest rates fall below zero. Investing is about to get weird.
In a zero interest rate world, everything is nonsense. But nonsense interest rates do not change the fundamental truth of investing – the value of any asset is still determined by its future cash flows. The following example may help to illustrate this dynamic.
If we break down the value of a firm into two components – steady state value and future value creation – we can isolate the impact of interest rates on stock prices. The steady-state value of a firm is the value of a business assuming that it maintains a normalized level of profit into perpetuity. It can be derived by the perpetuity method, dividing the firm’s current net operating profit after tax (NOPAT) by its weighted average cost of capital (WACC).1
We can also use this formula to derive a steady-state price-earnings multiple, which is the reciprocal of the cost of equity. For example, an 8% cost of equity translates into a steady-state price-earnings multiple of 12.5 times (1 / .08 = 12.5). We’ve labeled this column Normal on the chart below. Moving from left to right, you can see the impact of lower interest rates on steady-state price-to-earnings multiples.
In looking at this chart, one might conclude that stocks “deserve” to trade at 25x earnings in the current interest rate environment. One might also surmise that fundamentals don’t matter at zero interest rates because any valuation can be justified. Or that traditional tools used to value securities no longer work in such an environment. Perhaps stocks really have reached a permanently higher plateau.2 If you find yourself listening to someone making these arguments today, we suggest you run as fast as you can in the other direction. This is not Cheshire Cat’s reality.
A Relic of the Past
The chart below is an illustration of the world we used to live in. Stocks have compounded at 11% annually since 1950. Bonds advanced 6% per year. Take a close look because you are unlikely to see these numbers again anytime soon. These returns are simply not on offer today.
A recent paper by McKinsey titled Why Investors May Need to Lower Their Sights concludes, “The forces that have driven exceptional investment returns over the past 30 years are weakening, and even reversing. It may be time for investors to lower their expectations.”
The author’s “detailed analytical framework” suggests that stock and bond returns could be considerably lower over the next two decades. The summary is worth a read but we think sixty pages of detail still missed the mark. Investors only need to consider a few key points to reach a similar conclusion.
Real returns on equities have averaged 6.5% over time. McKinsey forecasts 4.0% – 6.5% real returns going forward. That’s probably best case. The base case is likely lower due to four factors:
- The population is aging and productivity is declining. As a result, trend growth has slowed.
- It is impossible for interest rates to decline as much as they have over the past few decades.
- Profit margins are near all-time highs. It is not impossible for them to go higher. It’s just not a high probability outcome. Margins are the most powerful mean reverting force in finance.
- And valuations are hovering in bubble territory. Again, not impossible for expensive stocks to get ridiculously expensive, but not great odds either.
Expected returns on all components of a conventional asset mix (stocks, bonds, and cash) are now as low as they have ever been. The chart below shows ten-year expected returns (blue line) on a conventional asset mix, along with actual subsequent returns (red line). If the glove fits . . .
There are two points of interest on this chart. The first is the spike higher in the blue line in 2008-2009. During the financial crisis, expected returns on a traditional portfolio reached 8% as asset prices collapsed. Those brave enough to put capital to work during the crisis have been rewarded.
The second point of interest is in the lower right corner. The most recent data point suggests that investors should not be surprised by forward returns closer to 2% over the next decade. Those daring enough to put capital to work today will likely be punished.
Rolling the Dice
The market doesn’t always generate the returns reported by historical averages. Average rarely happens. And the market won’t give you 6% – 8% just because you need it.
Even in today’s nonsense interest rate environment, two plus two still equals four. Central banks can’t change that math. Yields on bonds are near zero today. Expected returns on stocks are not much better. You can arrange those numbers any way you’d like, but you won’t get them to add up to the 6% – 8% returns investors have grown accustomed to.
This is the challenge all investors face today. There are a few potential responses:
- The majority will do nothing. They will close their eyes and hope the market provides the returns they need. They cannot afford to be wrong. They likely will be.
- Conservative investors will make the difficult but necessary adjustments to protect their wealth. The most effective way to accomplish this is the most un-American: save more; spend less.
- Rather than face reality and tighten their belts in expectation of lower future returns, many investors have found a more acceptable solution.
The third option was outlined for investors in a recently WSJ article which explained why many pension funds are taking more risk to achieve the same required return.3