Here’s the deal: you lend me $100. I pay you back $100 in the year 2066 with no interest in between. Does that sound fair? Would you take that deal? Well that’s what the Swiss government is currently offering – and many investors are taking it.
We are living in a very strange and unprecedented financial world where, upon last check, there were US$15 trillion in negative yielding government bonds out there; and US$30 trillion yielding less than one percent per annum. Even in Australia, the Commonwealth Government will pay you less than two percent per annum if you are okay with not being repaid your money until 2026. This is the lowest rate on record.
Much of the commentary on this subject has been around the impact of low interest rates on savers and retirees around the world. And it is upon these groups that low rates have the largest impacts and future social consequences. But it is also worth considering whether or not low rates will impact the earnings of businesses – which are particularly relevant for stock market investors.
Similar to individuals, low interest rates, in effect, favour businesses that borrow and penalize businesses that hold cash. For those holding too much cash, many will use the low interest rate environment to borrow cheaply and pay dividends or buy back stock. This is likely one of the reasons Australian and global equity markets have remained buoyant of late.
But not all businesses can do this. Indeed, some businesses – such as banks and insurance companies – are required by regulators to hold a significant amount of cash or highly-liquid assets on their balance sheets.
Take Challenger (ASX: CGF), for example. Around one fifth of its profit margin in its annuities business stems from interest generated on shareholder funds. As rates decline, so too will this return. Fortunately for shareholders, however, Challenger is such a high quality business that it can likely maintain its profitability through other means.
What about QBE Insurance (ASX: QBE)? This business is highly exposed to interest rates – both in Australia and abroad. Last year, of the nearly US$1 billion the company generated in pre-tax profit, nearly half stemmed from income on fixed income securities, short-term money and cash. Declining rates create a significant headwind for QBE and it remains to be seen if the business can offset this in other ways.
Australia’s banks face a similar issue. Consider The Commonwealth Bank of Australia (ASX: CBA), arguably Australia’s highest quality bank. Of its $60 billion in shareholders’ equity, at least half is held in cash and liquid assets. As rates on risk-free assets approach zero (and turn negative), this creates an earnings headwind on these liquid assets held by CBA at the very least.
The above examples illustrate how the new low-rate world we find ourselves in can have real impacts on company profitability. So does this mean stock prices of these sorts of businesses will decline? Not necessarily. You see a stock price is crudely considered to be the product of a company’s earnings-per-share and a valuation multiple, such as a price-to-earnings ratio. While it may well be that earnings-per-share takes a hit for some companies that are required to hold excess levels of cash; valuation multiples typically move inversely to interest rates. The lower rates go, the higher valuation multiples tend to move. This effect could potentially more than offset the former impact of lower earnings. Investing has always been a challenging proposition. It has now become much more difficult.