Investment Insights -
Low interest rates are a positive for shares
When COVID-19 initially appeared, some people compared it to the seasonal flu and thought it would all be over by the Northern Hemisphere Spring. It is now over 170 days since the first case in Wuhan was reported and 100 days since the World Health Organisation (WHO) declared it a global pandemic. Yet, with countries starting to remove restrictions on gatherings, we are now seeing a second wave of infections. There is, therefore, little doubt that COVID-19 will impact the global economy for a considerable period of time. The chances of New Zealand and Australia creating a travel bubble this year also seem to be receding by the day.
Despite this downbeat prognosis, we remain positive towards growth assets, such as shares. As countries have relaxed their restrictions, economies have rebounded strongly. Some of this reflects pent-up demand and consumers adopting a desire to support their local communities. While we expect some of this rebound to fade, we still expect economic growth to slowly improve.
This reflects a view that governments and central banks have decided to do whatever it takes to revive the global economy. Governments have increased spending and are prepared to run large fiscal deficits. Centrals banks have cut interest rates and provided liquidity to ensure the orderly functioning of the banking system and financial markets.
In many ways, parallels between the current situation and World War II can be drawn. During the war, the Allied powers ran large fiscal deficits and did whatever was necessary to defeat the enemy. Interest rates were also held low, as central banks set the rate for government securities to help finance the war effort. For example, in the United States between April 1942 and July 1947, Treasury bills were capped at 0.375% by the Federal Reserve. At the end of the war, governments had high levels of outstanding debt and consequently kept interest rates low even though inflation started to rise. This meant the return that an investor received after inflation from their bank deposits was at times negative. The chart highlights that in the late 1940s and again in the 1970s interest rates after inflation were actually as low as -7%. Bank savings accounts were seen as more a safe place to keep money, rather than an investment strategy.
For investors today, while we are generally positive on the global outlook, we are not positive on fixed interest investments, such as bonds. The returns they offer are currently low and are likely to remain low for some time. But this is positive for shares and other growth assets. Most companies fund part of their operations by borrowing money. With low interest rates, the cost of this debt is lower. Other things being equal, these savings on debt costs go to shareholders. In addition, given interest rates are low, companies may decide to borrow more debt and invest this into, say, more plant and machinery. These investments should increase the companies’ efficiency and consequently their profit. Again, a net benefit to shareholders.
Interest rates are also at the core of all asset valuations. Financial markets price a company’s shares based on the discounted value of its future earnings. The lower the interest (or discount) rate, the higher the valuation of the company. This means that, while today shares may look expensive compared with historical measures, high valuations may more reflect a new valuation paradigm.
Humans tend to be most innovative during stressed periods as captured by Plato’s quote, “Necessity is the mother of invention”. Research1 undertaken after the last recession in 2009 showed that more than half the companies on the Fortune 500 list were launched during a recession or bear market. Today, more than ever, we believe growth assets should form a larger component of most investors’ portfolios and shares will benefit from the innovations and changes that the last 100 days will inevitably bring.
Growth assets come with additional volatility. Shareholders should be in for the long haul. This is why putting in place a financial plan and staying the course is so crucial. A well-structured financial plan can include identifying money required in the short term and investing this in cash and fixed interest assets despite their poor expected returns. By separating out this money, the remaining portfolio can be invested in growth assets, whose returns over the long term should more than compensate.
Despite this downbeat prognosis, we remain positive towards growth assets, such as shares. As countries have relaxed their restrictions, economies have rebounded strongly. Some of this reflects pent-up demand and consumers adopting a desire to support their local communities. While we expect some of this rebound to fade, we still expect economic growth to slowly improve.
This reflects a view that governments and central banks have decided to do whatever it takes to revive the global economy. Governments have increased spending and are prepared to run large fiscal deficits. Centrals banks have cut interest rates and provided liquidity to ensure the orderly functioning of the banking system and financial markets.
In many ways, parallels between the current situation and World War II can be drawn. During the war, the Allied powers ran large fiscal deficits and did whatever was necessary to defeat the enemy. Interest rates were also held low, as central banks set the rate for government securities to help finance the war effort. For example, in the United States between April 1942 and July 1947, Treasury bills were capped at 0.375% by the Federal Reserve. At the end of the war, governments had high levels of outstanding debt and consequently kept interest rates low even though inflation started to rise. This meant the return that an investor received after inflation from their bank deposits was at times negative. The chart highlights that in the late 1940s and again in the 1970s interest rates after inflation were actually as low as -7%. Bank savings accounts were seen as more a safe place to keep money, rather than an investment strategy.
For investors today, while we are generally positive on the global outlook, we are not positive on fixed interest investments, such as bonds. The returns they offer are currently low and are likely to remain low for some time. But this is positive for shares and other growth assets. Most companies fund part of their operations by borrowing money. With low interest rates, the cost of this debt is lower. Other things being equal, these savings on debt costs go to shareholders. In addition, given interest rates are low, companies may decide to borrow more debt and invest this into, say, more plant and machinery. These investments should increase the companies’ efficiency and consequently their profit. Again, a net benefit to shareholders.
Interest rates are also at the core of all asset valuations. Financial markets price a company’s shares based on the discounted value of its future earnings. The lower the interest (or discount) rate, the higher the valuation of the company. This means that, while today shares may look expensive compared with historical measures, high valuations may more reflect a new valuation paradigm.
Humans tend to be most innovative during stressed periods as captured by Plato’s quote, “Necessity is the mother of invention”. Research1 undertaken after the last recession in 2009 showed that more than half the companies on the Fortune 500 list were launched during a recession or bear market. Today, more than ever, we believe growth assets should form a larger component of most investors’ portfolios and shares will benefit from the innovations and changes that the last 100 days will inevitably bring.
Growth assets come with additional volatility. Shareholders should be in for the long haul. This is why putting in place a financial plan and staying the course is so crucial. A well-structured financial plan can include identifying money required in the short term and investing this in cash and fixed interest assets despite their poor expected returns. By separating out this money, the remaining portfolio can be invested in growth assets, whose returns over the long term should more than compensate.
Source: Stats NZ, RBNZ, IMF. Government bond yields are used as a proxy for deposit rates prior to 1965.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
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David Wilson is Investment Strategist for New Zealand Funds Management Limited (NZ Funds) and a member of the NZ Funds KiwiSaver Scheme. David's comments are of a general nature, and he is not responsible for any loss that any reader may suffer from following it.
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