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Last week, I raised the question that every value investor should be asking themselves: If benchmark interest rates remain near historical lows, and the U.S. Federal Reserve and other global central banks continue to buy up government and corporate debt, how does one determine the appropriate hurdle rate for investment? Unsurprisingly, I am not the only person thinking about this. In a recent interview with Bloomberg, Bridgewater Co-Chief Investment Officer Bob Prince offered a number of thoughts on this question, as well as some observations on the state of the U.S. dollar as the world's reserve currency.
On fiscal stimulus
As has been noted by several other commentators, it seems likely that the Fed and U.S. Treasury will have to extend their emergency support to companies and individuals in order to meet the demand and spending shortfall created by the lockdowns of the past few months. This likely means more "free" money and zero-interest rates. Prince discussed the implications of zero-rate policies for value investors:
"It's really a mind-blowing thing. When you have a zero-interest rate on the Treasury bond, that means there is no interest rate! If there is no interest rate, there is no discount rate on cash flows [either]. So how long is the duration of cash flows, and what is the present value of cash flows that have no discount rate (except for the risk premium)."
Prince went on to say that these policy shifts have created a number of problems for the traditional "60-40" (60% stocks, 40% bonds) portfolio, as bonds are currently yielding very little. To make matters worse, the payoff is asymmetrical - in the best-case scenario, bond investors can hope to make 5% to 7% over the next few years, but the downside could be as big as 20% to 30%, especially if inflation picks up (as the real value of the cash payments from the bonds will decrease).
He also noted a number of problems for stock investors. Since rates are already incredibly low, it becomes more difficult for policymakers to set a floor for the stock market. Of course, the Fed has yet to follow its European and Japanese counterparts into their experiment with negative interest rates, so theoretically they could go lower.
However, it seems safe to say that such an experiment will have a number of unintended consequences . For instance, how do you value a company with large amounts of debt in a negative rate environment? Classical value analysis would identify a large debt burden as a risk, but if that debt starts generating cash, does it become an asset? No one really knows.
Could these policies undermine the status of the U.S. dollar as the main world reserve currency? Prince certainly seems to think so. In the next part of this interview, we will look at his comments on gold and the state of the U.S. dollar as its stands today.
Read more here:
- Howard Marks: The Long-Term Consequences of Government Stimulus
- David Einhorn's Greenlight Is Still Short Tesla
- Seth Klarman: Don't Target Specific Returns
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