April 19, 2015
Interest rates are one of our best tools for figuring out what is going on in the economy, and for guessing what is most likely to happen next. Low interest rates spur economic activity by making it easier for both people and companies to buy things. Lower mortgages allow renters to buy and move into houses they own, and cheap bank loans encourage businesses to buy long term assets to increase production and improve productivity. At the same time, however, low interest rates discourage saving and encourage current consumption. In addition, they are rightly seen as a slow but steady transfer of wealth from owners of capital, who look to earn interest, to borrows of capital, who are payers of interest. What can we guess about the future from the state of interest rates in Canada today?
Right now, interest rates are very low. For only the second time in the entire post-Second World War era, owners of Government of Canada 10 year bonds are earning interest that is lower than the rate of inflation. That is, they are suffering a negative real rate of return (and this does not even take taxes into account). This chart shows the real return over the past fifty-seven years.
The last time real returns were negative was in the high inflation era of the 1970’s. Although nominal rates were high (Canada long bonds averaged an interest rate of 8.9% in 1974), inflation was even higher. Savers demanded higher and higher nominal rates, culminating in a prime rate of 22.5% in 1981 and a long Canada bond rate of 15.22% in the same year. Those very high rates finally broke the back of inflation by making the real cost of borrowing so prohibitive that economic activity was choked off. A vicious recession, the worst until our recent experience of 2008/2009, led to a sharp drop in inflation and in nominal interest rates. However, real returns remained very high for almost twenty years, only falling to the long term average of 3.2% in 2001.
Clearly the situation right now is very different. Instead of high inflation, governments are worried about no inflation, or even deflation. Nominal interest rates are flirting with zero for short duration deposits, and have gone below zero for longer bonds in countries such as Germany and Switzerland, something that economists thought could never happen in the real world. So, unlike forty years ago when real returns were negative while nominal interest rates were high, we now have negative real returns with very low or zero nominal rates.
The negative returns of the 1970s were cured by reducing the rate of inflation. How can the negative returns of today be fixed, when inflation is already so low? Clearly, only by raising nominal interest rates. But increasing rates comes with a real risk. If rates rise too high too fast, just as in 1981, they will start to choke off economic activity. Housing, already expensive, will become increasingly unaffordable, leading to a sharp drop in construction, and likely a drop in housing prices. Businesses will cut back on expansion and on hiring, leading to increased unemployment. Eventually, a recession will ensue. In short, the cure would end up being worse than the disease.
Most economic observers, ourselves included, had expected that increasing economic activity would have led to higher employment and higher output by this stage in the recovery. We are seeing some evidence of that in the U.S., and even in Europe, but not in Canada. In fact, low commodity prices, especially for oil and gas, have already cut deeply into Canada’s economy, reducing growth and lowering employment. Any room the Bank of Canada had for increasing interest rates without killing economic growth disappeared when crude oil prices fell in half.
Our conclusion is that low interest rates and very low to negative real returns will be with us for at least the next year, and possibly considerably longer. Owners of capital will not be rewarded with real interest rate returns that are even close to the long term real return of 3.2%. Bonds, already unattractive, will not become any better looking in the next twelve to eighteen months.
Investors buy bonds not only for the modest real return they usually provide, but also to act as stabilizers in their portfolio. While stocks may be volatile from day to day and from month to month, bonds change price quite slowly and if held to maturity, will always return capital to the owner (assuming prudent credit risk). This is a quality not to be undervalued or ignored. In 2008/09, investors were grateful to have boring bonds in their portfolios as the stock markets imploded. However, too much of a good thing is not a good thing at all, and right now, bonds are not that good a thing.
In consultation with our clients in our portfolio review meetings, we have been discussing this dilemma, and in large numbers our clients have chosen to alter their portfolio asset allocation to reduce the weighting in bonds and increase the weighting in stocks. Our analysis supports this decision. There is no doubt that these clients will experience more short-term volatility, but we believe that reducing the value of assets that produce a negative real return is the right decision over a longer time period.