Away with tradition
The impact of the 2008 financial crisis continues to reverberate. The painful and long-lasting consequences have inhibited post-recovery GDP growth substantially. Traditional monetary policy was found to be ineffective in addressing the consequences of the Great Recession and central banks have had to adopt unconventional mechanisms, such as quantitative easing and near-zero interest rates. This has raised concerns about a number of unintended consequences, which experts fear could pose major challenges to the financial services industry and the real economy going forward.
The risks to individuals because of the low/zero interest rate environment are well documented. Savers ultimately suffer. The low interest rate equates to a low, and in some cases negative, real rate of interest, meaning cash-based wealth accumulation is negligible or very slow. This is a far cry from the early 1990s, when real interest rates in the EU were high (5% or more depending on the country) and the reinvestment of the proceeds of low-risk investments (cash and government bonds) meant steady accumulation of financial wealth.
In a zero or negative interest rate environment, real wealth does not grow (or even decreases) unless people save. Individuals have to save even more than before, otherwise they would expose themselves to financial risk (as when households reaching the age of 70 or more realise they have outlived their financial means and need alternative funding). Increasing the savings rate today is especially challenging for people who are still repaying mortgages.
The challenges faced by institutional investors should not be underestimated, either. Many institutional investors in the pension fund arena face severe asset liability mismatches. Defined benefit (DB) pension schemes, which guarantee a certain level of income to fund members, typically have a balanced portfolio of equities and bonds (the latter are potentially for liability matching purposes). Low/declining interest rates mean that the actuarial liabilities of DB schemes increase even if automatic pension increases remain low.
Managing the risk-exposed part of the portfolio (equities, corporate bonds and so forth) may become a real challenge when valuations become stretched on the back of non-conventional monetary policy.
This slow increase in the value of pensions is impacting on households, who must now ensure that they have sufficient savings or income to live on in retirement. Many DB schemes are hoping for a rate rise to help overcome their liability mismatches. Nonetheless, the ongoing zero/low interest rates and slow growth in pensions are a significant issue for future retirees and their income.
Corporates are also exposed to low interest rates. Those wanting to borrow will benefit (provided their credit quality is good), but the low interest rate environment could lead to ‘evergreening’, whereby corporates obtain new loans to repay existing ones.
This is a characteristic of low interest rate environments and often masks broader corporate difficulties: companies which should have defaulted or undergone massive restructuring are simply able to roll their loans over and maintain the status quo, and there are still players in the market that should not be there. This in turns weighs on the profitability of healthier companies.
This is precisely what happened in Japan in the 1990s; there is concern that today’s low interest rate environment could be repeated in several countries. In a similar vein, there is a worry over a lack of fiscal discipline as, for example, sovereign spreads are continually falling as the European Central Bank (ECB) is buying assets. This means the market and interest rates are no longer playing the disciplinarian role they ought to be.
A major challenge in the next downswing will be the phenomenon of persisting historically low interest rates, leaving little room for manoeuvre to cut them. In the US, where a significant slowdown is likely within the next three years on the back of Fed tightening, rates may very well peak no higher than 2.5% – a far cry from previous levels. This may mean a return to non-conventional monetary policy, even though it may not prove to be as effective as it once was.
As a consequence, fiscal policy may be expected to have a bigger role in conjunction with monetary policy to support growth in future recessions (as is already the case in Japan).
This presents a significant challenge for the Eurozone, in particular due to the lack of a unified fiscal policy framework.
In the US and the UK, on the other hand, implementing this policy mix should be less of an issue. International differences in the ease of implementation will have major implications in different markets, with foreign exchange markets being a prime example. A rise in interest rates by the Federal Reserve looked likely when this magazine went to print, as did another bout of ECB quantitative easing.
China remains a question mark. Industry participants were alarmed over the summer months by the stock market volatility and subsequent government intervention and by the currency devaluation which, although small, came as a surprise. However, we believe the cyclical slowdown in China will trough around the end of the second quarter of 2016.
What happens to China’s economy is also important for developing economies as many continue to suffer from the fall-out from the commodities shock.
The latter is having a profound impact on corporate P&L in emerging economies due to declining export prices, lower export volumes and weaker currencies. This is also driven by the fact that China is buying less from its international trading partners. More emerging market companies could default than normal in the slowdown, which could have a knock-on effect on the banking sector in those economies.
Another area that will have major ramifications on the global economy is regulation. Regulations requiring banks to bolster balance sheet capital, such as Basel III, are designed to prevent a rerun of 2008, but risk putting pressure on the banking model by restricting lending (a balance-sheet intensive activity).
This could also have a major impact on the wider economy. European policymakers have highlighted that the Capital Markets Union (CMU), a pan-EU initiative to attain harmonisation across financial services, will facilitate more ‘alternative’ or non-bank lending.
This has created great excitement around the role of capital markets and the part they will play in Initial Public Offerings and start-ups coming to market, but the initiative will take time to develop and implement.
Meanwhile, regulation such as the Markets in Financial Instruments Directive II (MiFID II) will have a significant impact on individual investor approaches to allocating investments.
MiFID II obliges financial institutions to check whether their clients are eligible for the investment products they are selling to them; some investors may be required to undertake a financial competency test.
This could have a major impact on how those individuals invest in order to maintain their existing living standards. In parallel with the cyclical developments and the changes in regulation and market infrastructure, important changes are taking place on the supply side of the economy: the effectiveness of companies to address the challenges posed by digitisation to their businesses is a growing issue.
Firms that thrive with digitisation will be able to tap the stock market to fund growth, whereas those who fail to adapt risk a precipitous decline in their stock market value.
This new environment will force corporates to think in terms of Valuation at Risk (volatility in price/earnings multiple) rather than Value at Risk.
Households, companies, banks, governments and markets all face a number of challenges. These include, among other things, structurally slower growth, an uncertain interest rate outlook, the need to boost savings, bank regulation issues, corporate indebtedness in developing economies and new regulation.
These factors will all impact how companies and governments finance themselves and how investors allocate their capital. Economic policy will need to take account of this structurally more complex world.
Read this article as it appeared in Quintessence magazine (Winter 2016)
"Away with tradition"