Investing in a world of negative interest rates

Why interest rates are turning negative

In normal times lenders have insisted on borrowers paying them interest in return for lending their money. The rate of interest has varied depending on how likely the borrower is to pay the money back along with compensation for the fact that money will lose some of its buying power through inflation.

This arrangement was turned on its head during the last recession as central bankers cut interest rates and printed money (via a process known as quantitative easing where central banks created money out of fresh air and used it to buy bonds, which pushed up their prices and pushed down market interest rates) in the hope that governments, households and companies would borrow money and spend it, and in so doing revive struggling economies.

This policy has not really worked that well in many countries. Yes, in most cases, the size of the economy has grown, but the rate of growth has been weaker than before the last recession. Debt levels have increased faster than the size of economies, which shows that borrowing has not been great at delivering a bang for its buck. There is a strong argument that suggests things would have been worse without this, but there can be no question that achieving sustainable economic growth has been tough.

The worry now is that economic growth across much of the industrialised world is slowing down sharply and that economies could start to shrink in size and enter a period of recession. A trade war between the US and China is showing signs of hurting both countries’ economies, the eurozone looks very weak, the UK economy is stagnating.

The prevailing view among investors is that interest rates are going to have to be cut to fend off a recession. This has seen the price of government bonds soar as investors look for safer havens and interest rates fall and in many cases turn negative. Over $17 trillion of government debt across the world now has a negative yield.

Government bond yields

Source: Financial Times

In the UK and US, the cost of government borrowing is close to record lows and has fallen sharply in recent weeks.

In the US, the yield curve has inverted, which means that long-term interest rates are lower than short-term interest rates. This is often seen as a prediction of a recession where interest rates are expected to be cut in the future.

A year ago, the expectation was that interest rates were going to be increased as the US economy kept on growing.

Bond markets therefore seem to be predicting a very grim outlook for the world economy.

Interest rates and the value of investments

So why does this all matter? The reason is that the interest rates or yields on government bonds determine the value of most investments as they are used to price the future cash flows that come from them. This is all to do with something known as the present value of money and the maths behind it.

Stay with me and hopefully everything will become clear. To me, the whole point of investing is to grow the value of your savings. I want the money I invest today to buy me a lot more things in the future than it does today.

So if we are given the choice of having £100 today or £100 in a year’s time, most of us should choose £100 today. Why on earth would you wait to be given exactly the same amount of money? We need some kind of incentive to wait. 

This incentive comes from being offered a return on your money on top of the £100. If you were to put your money in a savings account or bonds that return would come in the form of interest income earned on your money – your £100. The value of a bond investment can change as well during its life, but to keep things as simple as possible I am going to ignore this for now.

Putting money in a bank account

Let’s start with a simple bank account and say that the bank offers you an annual interest rate of 5 per cent on your £100. So in one year’s time £5 will be added to your £100 and you will have £105. 

So with interest rates at 5 per cent you can say that £105 in a year’s time is the same as £100 today. Or you could say that £100 is the present value of £105 in a year’s time discounted at an interest rate of 5 per cent.

Here’s the very simple maths that explains this:

Future value = £100 x (1.05) = £105 (1+5 per cent is the same as 1.05)

Present value = £105/1.05 = £100

If we want to work out the present value of money we use what is known as a discount rate. A discount rate is best seen as an interest rate working in reverse. You use it to reduce the value of money in the future to give it a value today.

The other way to do this is to multiply a future value by something known as a discount factor. Using a 5 per cent interest rate the discount factor to calculate a present value of something one year from now would be:

1/1.05 = 0.9524. 

So £105 x 0.9525 =£100.

So if you know or have 1) the future cash flows of an investment and 2) an interest rate, you can get an estimate of how much something is worth. This type of approach works best with bonds because all the cash flows are usually known. But the approach is also used to value shares where the cash flows are not known and rely on forecasts of future growth.

Let’s use a government bond as an example. A government decides to issue a 10-year bond with an interest rate of 5 per cent, which is the current market rate demanded by bond investors. The bond is initially sold to investors with a principal or par value of £100.

• The cash flows for this bond are made up of £5 of interest every year for 10 years and the return of £100 at the end of the tenth year (so £105 is received in year 10),
• The interest rate to discount the cash flows is 5 per cent. That’s the return that bond investors want to part with their cash.

The value of the bond is calculated in the table below by adding up the sum of all the present values. In this case, the value is £100 – the same as the price of the bond. That is what the bond is worth to someone wanting a 5 per cent return per year for 10 years.

If the day after the bond is issued, market interest rates fall to 3 per cent then those £5 cash flows and £100 back after 10 years look very attractive to interest seekers at a price of £100. Unsurprisingly the price gets bid up as their present value becomes more valuable.

Anyone, paying £100 for the bond and holding on to it for all of its life would get a gain of £17.06 – a positive net present value or NPV – and so when the present value of future cash flows becomes more valuable with a fall in interest rates that gain tends to disappear for new buyers (but not existing ones) as the price of the bond increases.

What is going on at the moment is that investors are placing much higher values on the cash flows from bonds. So much so that new buyers are certain to lose money. If we take our current bond example and see what would be needed to give it the same yield to maturity of minus 0.7 per cent as being currently offered by German 10-year government bonds it paints a very revealing picture.

What it means is that an investor is paying £159 today to receive £150 in future cash flows – a £9 loss. The price of £159 for the bond is effectively saying that the £5 of future cash flow is effectively worth more than £5 today. This can only happen if the buying power of £5 will increase because the prices of goods and services fall – deflation in other words.

The other plausible explanation is that bonds are grossly overvalued. The best way to think about the relationship between interest rates and the value of investments is that they are like a seesaw. When one of them is up, the other one is down. With shares, the future growth of profits is also a key determinant.

What are investors to make of these negative yields? Let’s look at the possible implication for the asset classes of shares, bonds and precious metals that arise from this situation. Of course, no one can predict the future with a high degree of accuracy but I’ll share my thoughts as to what might happen.

Shares

Falling interest rates have given a great boost to shares since the financial crisis, especially those in the US. The expectation of growing future profits and cash flows from companies become more valuable at lower interest rates. Expectations of higher rates have the opposite effect, as was seen with the sharp reduction in share prices at the end of last year.

The big question is whether that relationship will stay in place. Stock market bulls will point to the fact that shares offer more income than bonds, but I find that view rather simplistic. The value of shares is not just determined by their initial yield but expectations of future growth in profits, cash flows and dividends.

If the yields on government bonds are falling or already negative and this is due to the expectation of weakening growth then this is hardly a bullish backdrop for company profits. Profit warnings have been increasing in 2019, while analysts’ expectations of future profit growth have been coming down. You’d think this would be a recipe for falling share prices.

Yet 2019 has been a good year for shares so far. The FTSE All-Share index has returned 12.7 per cent in the year to date, but any UK investor that has owned a S&P 500 ETF has gained 23.5 per cent where the fall in the value of the pound has given a kicker to the 15.9 per cent increase in the index in dollar terms.

UK shares can be seen as being inexpensive, but this may be a true reflection of their poor growth prospects. The S&P 500 trades on a trailing price/earnings (PE) ratio of 21.6 times against a long-term average of just under 16 times. This does not signal that US shares are desperately expensive given low interest rates, but they are not at levels at which a bull market begins from.

The key to the direction of stock markets will be profits growth. A weakening outlook does not bode well, but for the markets to crack profits will have to fall heavily in my view and a big blue-chip profit warning could be the catalyst. I struggle to see much upside in the short term.

If profits growth falters then the free lunch of lower interest rates that equity investors have dined out on for the past decade will be taken away. This is what preoccupies the minds of many investors today.

In terms of individual shares, falling interest rates are likely to put further pressure on companies such as BT (BT.A) with very large pension fund deficits.

Bonds

As I have discussed earlier, low and negative yields show that bonds are very expensive and do not currently increase the buying power of investors’ money. However, that doesn’t mean they won’t get more expensive, which is currently my view.

For UK investors in recent years, owning bonds has delivered a better outcome than owning shares. The iShares Index Linked Gilt ETF (INXG) has returned 16.3 per cent in the year to date and 55.4 per cent over the past five years. The Vanguard UK Government Bond ETF (VGOV) has respectively returned 12.4 per cent and 35.4 per cent; the FTSE All-Share 12.7 per cent and 32 per cent.

With conventional gilts still offering a positive yield there is still maybe some upside if yields turn negative. 

Index-linked gilts look very expensive. The March 2029 gilt has a negative yield of 3 per cent. The break-even inflation rate on a 10-year bond (the inflation rate needed to give the same nominal yield as an equivalent maturity conventional gilt) is around 3.4 per cent. A big fall in the pound could see inflation take off and make index-linked bonds look a good buy, while further falls in interest rates could see prices continue to rise.

If you are a bond bull then the US Treasury market could be the best place to go. Interest rates remain a lot higher than most of the developed world. Further interest rate cuts in the US are expected and it is not too far fetched to think that yields could go negative here as they have in most of Europe and Japan if the Federal Reserve goes for an aggressive stimulus policy.

At the moment, it’s difficult to see where a rise in interest rates is going to come from to kill off the bond bull market. A currency crisis could see interest rates being used to defend a currency, but short of that the current interest rate environment looks favourable.

The real enemy of bond investors remains inflation. Central bankers think it is too low and negative yields suggest it is not increasing anytime soon.

Gold and silver

Gold prices are up by 20 per cent so far in 2019 with silver prices up by 24.4 per cent. Precious metals are often scoffed at by equity investors for their lack of income and volatility.

I think the mockery of gold is misplaced. Its volatility can be horrendous at times and should not be ignored, but it has a role in investment portfolios, especially given the current market backdrop. Over the past 20 years, gold has comfortably beaten the performance of shares and bonds, but has been disappointing since its price peaked in 2011. Since 1971 when Nixon removed the relationship between gold and the US dollar, gold has increased in price 44-fold, the price return for the S&P 500 is up by just over 28 times. With dividends reinvested, the S&P has trounced gold and would have increased in value over 114 times.

Yet gold’s appeal increases when the income returns from bonds is negative. Investors holding a zero-income-producing asset are not losing out. If central bankers are intent on devaluing the buying power of money by printing lots of it then gold – which cannot be created out of thin air – looks increasingly attractive to me.

It will take some time, but there is a growing realisation that the world’s experiment with paper money since 1971 has created a lot of problems, especially with the build-up of credit in economies. A new monetary system is needed and precious metals such as gold could be part of it.

The problem with being bullish on gold is that by implication you are pretty much bearish on everything else. Yet the ongoing US-China trade dispute and weakening growth and negative interest rates have seen investors flocking to it in recent months.

Silver usually lags the gold price, but has many of the same fundamentals behind it as gold. Silver bulls will point to the gold-to-silver price ratio, which is near historic highs as evidence that silver’s catch-up rally has more legs. Silver’s industrial uses do perhaps make it a more risky proposition if economic growth slows, though.