During times of crisis, investors look to their role models to gauge a measure of how panicked they should be. Warren Buffett (Trades, Portfolio) is arguably the most-followed guru of them all. Beyond the scope of stock tips, Buffett is known to provide invaluable investment advice that could shape the portfolio of an investor in a way that could generate stellar returns over the long term.
When the Federal Reserve decided to cut the target funds rate by 100 basis points on March 15, the intention was to boost credit growth in a bid to revive economic expansion. When markets opened for trading on Monday, however, stocks continued their selloff despite the measures taken by policymakers to stabilize economic activities. This is a clear indication that market participants do not keep faith with the decision-makers. With rates near zero, the world is watching whether the United States will be pushed into negative yields territory. Yahoo Finance Editor in Chief Andy Serwer contacted Buffett on Wednesday to gain some insights into the this trend. When asked about negative rates, Buffett said:
“I would say that’s the most important question in the world. And I don’t know the answer. Now, if we knew the answer, it wouldn’t be the most important question.”
Later in the interview, the guru was asked whether investing in equities would change given the current interest-rate environment, to which he replied:
“It reduces the hurdle rate. That’s why they like to decrease it. It pushes asset values higher.”
Finally, Serwer wanted to know whether Buffett is scared of negative rates. After reiterating that his and Charlie Munger (Trades, Portfolio)’s focus is entirely fixed on identifying attractive investment opportunities, with a smile on his lips, Buffett said:
“They puzzle me. But they don’t scare me.”
If the Oracle of Omaha is not worried about negative yields, should retail investors be? The subject of this analysis is to find an answer to this all-important question.
The United States is not the first country to be here
As unfamiliar as sub-zero rates might be to the U.S., there are a few countries that have experienced such a macroeconomic environment in the last decade. A few European nations have seen persistently low rates, along with Japan. The table below summarizes a few important details about this phenomenon.
| Country/region | Current policy rate | The year in which zero rates were first reported | Lowest reported rate |
| Sweden | 0% | 2015 | -0.5% |
| Denmark | -0.75% | 2013 | -0.75% |
| Eurozone | 0% | 2016 | 0% |
| Switzerland | -0.75% | 2011 | -0.75% |
| Japan | -0.10% | 2010 | -0.10% |
Source: Trading Economics
According to economics theories, there could be two primary motivations behind negative rates.
- Stimulating inflation.
- Defending the local currency.
The regions that are experiencing record low rates are developed nations. The next important step in this analysis is to evaluate the economic growth of these regions since hitting zero percent rates and determine whether the targets behind setting such rates have been achieved.
Not so impressive results
None of the countries that have implemented negative rates have been able to meaningfully improve their economic growth. One could argue that if not for historically low yields, the economies of these countries would have collapsed. While that is a valid statement, Alex Graham, former treasury manager at Investec London, believes this had led to new asset bubbles instead of giving the expected benefits to the economy. The Denmark property market is a classic example. According to data from Reuters, real estate prices have skyrocketed over the last several years as investors flocked to buy houses at rock-bottom rates instead of riskier choices such as equities. The chart below plots the economic growth of countries with sub-zero yields.
Source: World Bank.
Despite the monetary policy stimulus, these countries have grown in line with the average world growth rate of 2.5%. The U.S., which has a much larger economy than the eurozone, could still grow at similar rates even when rates remained well and truly positive. This is a clear indication that low rates have not been as successful as they were thought to be.
Will it be effective in the United States?
This is a question that even the great Oracle of Omaha doesn’t have an answer to. Therefore, it would most likely be fruitless to debate over whether this is good or bad for the economy. Even though the underlying idea is to incentivize borrowers, banks are hesitant to provide free credit to small and medium enterprises in fear of being responsible for creating credit bubbles. This was seen in Japan and Denmark in the last few years.
The Federal Open Market Committee, at its October 2019 meeting, commented that negative rates would do more bad than good to the United States economy. Fed Chair Jerome Powell said:
“Negative interest rates would entail risks of introducing significant complexity or distortions to the financial system. The Financial system in the United States is considerably different from those in countries that implemented negative interest rate policies, and that negative rates could have more significant adverse effects on market functioning and financial stability here than abroad.”
Banks would particularly be in the spotlight as net interest margins would come under pressure. Small, regional financial services companies would be the most vulnerable because of their limited balance sheet strength.
If negative rates are implemented, investors need to carefully evaluate the progress of the economy on a quarterly basis to gauge a measure of the effectiveness of such a decision. For now, the big picture is clearly uncertain.
Buffett’s neutral stance is a reflection of his investment strategy
The guru is an equity market investor and has successfully picked winning companies for decades. His investment strategy is based on identifying companies that will deliver robust financial performance under various macroeconomic conditions. Therefore, even during a negative rate environment, Buffett should be able to filter out the companies that will perform relatively poorly from the companies that will likely generate attractive returns.
For retail investors with exposure to bond markets, however, things will be different. A persistently low interest rate environment will lead to a bloodbath in bond markets as fixed income securities are inversely correlated with policy rates. The best alternative is to shop for dividend-paying companies with a strong track record of distributing wealth to shareholders during trying times. GuruFocus Screeners can be useful in identifying such companies.
It would be a futile task to spend time and money on analyzing whether the United States would benefit from zero or negative policy rates on a country level. There could be winners and losers both. As Buffett suggests, the best way forward is to dig deep into company fundamentals to unearth any possible relationship between corporate earnings and interest rates.
Investment strategy tips to generate alpha with rates near record lows
Financial services companies are trading at very cheap multiples. According to data from GuruFocus, the Shiller price-earnings ratio of this sector is 13.7 in comparison to the market multiple of 22.1. This is an indication of a possible undervaluation. However, a convergence might not occur for a long time because of the underlying interest rate environment. Therefore, investors need to conduct thorough due diligence and identify catalysts with some degree of precision before investing in this sector.
Some of the industries that would benefit from ultra-low rates are listed below. With markets on a freefall, leading companies operating in all these segments of the economy can be picked at bargain prices.
- Consumer staples companies
- Utilities
- Health care companies
- Commodities
- Dividend-paying companies
Stephen Covey, the author of "The Seven Habits of Highly Effective People," famously said, "You take control of that which you can control." This advice is relevant to today’s investors. There are limitations in assessing whether negative rates would provide the desired effects in the United States and an investor does not have control over these policy decisions. The only controllable element here is the investment decision-making process. Therefore, the focus should be on building a diversified portfolio that is likely to survive a range of interest rate possibilities, and investing in defensive industries will play a major role in doing that.
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