Rates will likely remain lower for longer, as explained in "Rates: Lower for Longer." And we are wary of the distortive consequences of low rates, much of which will relate to sluggish growth caused by persistent malinvestment.
At the epicenter of this lower-for-longer environment is the transfer of wealth from creditors to debtors—such as sovereign borrowers—further penalizing savers and worsening income inequality. Since many people have missed expected life improvements from policy actions, populist movements have been able to flourish.
These movements risk nourishing destructive policies of isolation and wealth redistribution. Being able to understand these movements should help us navigate advantageously, and step in where populist movements are more benign than commonly perceived.
Persistent malinvestment resulting from low rates will likely have several other negative consequences.
1—More Zombies
First, the list of zombie companies—kept afloat by low interest rates despite excessive borrowing—is likely to continue growing. Some banks will avoid categorizing their loans to zombies as nonperforming by simply extending more credit.
We are also wary of zombie governments in the eurozone periphery, kept afloat by the now-explicit European Central Bank (ECB) bailout guarantee. Malinvestment of this sort will create policy burdens when an inevitable slowdown occurs.
2—A Boon to Lower-Credit Debt
Second, as implied by continued extensions of credit to zombie companies, as long as central banks continue their stimulative policies, lower-credit debt categories will benefit relative to higher-credit counterparts. Private credit providers will benefit by stepping in where myriad distorted incentives and complex regulations preclude public financial institutions from intermediating.
3—A Shift from Equity to Debt
Third, capital structures will shift away from equity and toward debt as companies secure long-term credit at rates below those implied by the natural interest rate. Share buybacks may not be a fleeting phenomenon of the post global financial crisis period. This could accelerate if the cost of equity capital increases in a bear market.
4—Overvalued Bonds
Fourth, whereas bonds are mainly overvalued in our view, we are hesitant to short bonds as it will likely take a long time for their yields to reach fundamental values.
An enormous obstacle to normalization is the burden that current debt levels would impose if rates were to increase. As long as the government pays less to borrow than the growth rate of the economy, it can keep the burden of debt in check. With higher rates, servicing this debt would be virtually impossible.
Meanwhile, we are seeing an unprecedented combination of company and household private sector debt, with student and auto loans contributing much of the growth in the latter. Rising interest rates in these categories would inevitably have an economic impact.
The people at the Fed are certainly aware of this and would hardly want blame for causing an historic American debt crisis.
5—Dampening Prospects for Carry Trades
Fifth, lower-for-longer dampens the prospects for carry trades in the major currencies, rendering reversion of exchange rates to equilibrium values more influential than interest differentials. High-carry currencies will benefit initially from interest rate convergence and carry decay, but exchange rate deviations from equilibrium will subsequently dominate the return from investing in fundamentally attractive currencies.
6—Consolidation
Sixth, protracted margin pressure at financial institutions will likely lead to consolidation. In the eurozone, elimination of regulatory differences with the Single Supervisory Mechanism and Single Resolution Mechanism will open doors to consolidation.
Artificially low rates are causing multiple distortions and pockets of heightened risks. However, for investors who understand these dynamics, they also bring about promising opportunities. The current environment may be unprecedented but it need not be incomprehensible.
Brian Singer, CFA, partner, is a portfolio manager on and head of William Blair's Dynamic Allocation Strategies team.
