Money only has value if there is a relationship with the value created in the real economy. So the value of money is not determined by the government, but by the private sector. The role of the financial sector is to allocate savings to those who can use them to achieve a higher return than the interest they have to pay.
The extremely low interest rates frustrate this system. Caveat emptor.
The financial world is about two connected things: time and risk. If a pension fund has a 30-year commitment and there is no longer a bond than one with a 10-year maturity, this can, in theory, be compensated by a larger position in a 10-year loan. Suppose the return on that loan was originally 5 per cent and drops to zero per cent. The duration (the weighted average life of the payments) of a 30-year loan then increases from 15.4 years to 30 years, while that of a 10-year loan increases from 7.7 years to 10 years.
Whereas previously two 10-year loans were sufficient to cover the risk of a 30-year obligation, the fall in interest rates will increase this to three 10-year loans. The fall in interest rates alone means that more bonds have to be bought, creating a self-perpetuating downward spiral in which “safe” government bonds become more and more expensive, depriving savers and bond investors of all their returns.
Interest rates are too low
This drop in interest rates to zero is the result of central banks keeping interest rates much lower than necessary. In the ideal situation, the interest rate is more or less equal to the nominal growth rate of the economy. Whoever can make a return slightly higher than the average (the nominal growth rate) can pay the interest on the debt. Such a situation automatically ensures innovation. Old and uncompetitive companies lose out to new, innovative and more profitable companies, if only because the old companies can no longer pay the interest.
Governments that are over-indebted allocate an ever-increasing share of the budget to interest payments and eventually fall into a debt trap. The central bank’s job is to keep interest rates in line with the economy’s nominal growth rate.
There are periods when this has worked wonderfully well, such as from the early 1980s to the beginning of this century. This ensures economic growth, falling unemployment and is also good for financial markets. This century, in particular, interest rates are much lower than the nominal growth rate. Borrowing money is interesting because the return (the nominal growth rate) is much higher. More and more borrowing is done to buy existing assets and less to invest in innovation.
An additional effect is that existing poorly performing companies do not go out of business because of the low interest rate and therefore prevent new competitors from innovating. This development is crippling for economic growth, but financial markets are decoupling themselves from the real economy by constantly rising valuations as a result of cheap credit.
Post-coronavirus monetary madness
Post-coronavirus is a new world. In large parts of the developed world (United States, United Kingdom and the eurozone), the government dictates how much money is created. This flows into the real economy thanks to government guarantees. This form of blanket credit has minimised the chance of things going wrong because a company is over-financed.
There is no longer any link between the amount of money and the growth of the economy. The creation of money has been nationalised, central banks are de facto part of the ministries of finance. It is not the private sector that decides how much money is needed, from now on it is the government that decides. Governments have a lot of debt, but thanks to low interest rates it is easy to carry. Unfortunately, governments have an unlimited need for money, which may result in an unlimited growth of the money supply.
The result is lower economic growth, higher prices and a lower standard of living. When there is too much money in an economy, it is important to distinguish between real assets (shares, raw materials, real estate) and contracts (loans, bonds, savings accounts). Real assets are by definition limited and therefore retain their value. Contracts are infinite, for paper is patient. Savers are punished, but unprofitable companies are allowed to continue to exist and therefore put pressure on the returns of healthy companies. This stands in the way of innovation and productivity, which ultimately benefits everyone.
Consequences for investors
In this situation it is important for central bankers and governments that the value of financial assets remains the same or rises, only then can the debts covered by these financial assets be sustainable. The central bank’s put option is stronger than ever. Ultimately, the assets with the longest duration benefit from this, and that is shares, especially growth shares. After all, the value of a share is determined by the present value of future cash flows and, with interest rates low or even negative, cash flows in the far future have become increasingly important.
This new post-coronavirus monetary system has only just started, with the risk of blowing bubbles again. If we draw a parallel with historical bubbles, we are only halfway there. This bull market will only stop when the economy falls into recession or equities have become more expensive than bonds. A recession is unlikely because of the coming Keynesian investment boom and the risk premium on equities is at its highest point this century.
Inflation is rising, but in the long run, companies are perfectly able to pass it on, while for savers and bond investors inflation is the biggest enemy. Because of these developments, especially the increased debt, many fear a new systemic crisis. The chance of that happening is not very great. Every country with its own currency can and will always pay off its debts in full; the big question is only what the value of that repayment still is at that moment.
So the big outlet for this financial problem is the value of the currency. Now the aforementioned Western central banks seem to be caught in a race to the bottom in this respect. The solution will probably have to come from Asia, through a revaluation of the Chinese renminbi. Hedging the currency risk to a currency where monetary madness has struck is then unwise. For those who want to escape this wealth trap, a well-diversified equity portfolio is the best alternative.
Han Dieperink is an independent investor, consultant and knowledge expert for Fondsnieuws. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. He is currently active as chief commercial officer at Auréus Asset Management. Dieperink provides his analysis and commentary on the economy and markets. His contributions appear in Dutch on Tuesdays and Thursdays on Fondsnieuws.nl and occasionally in English on Investment Officer Luxembourg.