The new low interest rate world in which we find ourselves is strange. Why does it make sense that an investor should have to pay for the privilege of lending to the German government for 20 years, for example? And yet, the yield on German 20 year bunds is negative – effectively implying exactly this.
There are many reasons why interest rates are low. These include: aging populations all around the world; very high indebtedness by many corporates and governments; an increasing dominance of technology which is relatively less labor and capital intensive; and an increasingly globalised world connected by US dollar-denominated trade – which, as it turns out, also contributes to the wave of global disinflation which is keeping rates low.
Should global interest rates remain lower for longer, there are significant implications for asset prices – including for equities. There are two ways to argue the effect of low rates on equities.
First, the bear case, which goes something like this. Interest rates are low because global economic growth is slowing. Slower growth naturally feeds into slower growing revenues for corporates, which slows the rate of earnings growth. Slower earnings growth should, in turn, result in lower valuation multiples. Therefore, this new world signals downside risk in equity prices.
Now here is the bull case. In a protracted lower interest rate environment, the implied “hurdle rate” of return demanded by equity investors may decrease. The logic here would be that, even while preserving the premium over the risk-free rate of return that equity investors demand for taking equity risk; the fact that global risk-free rates have largely stepped down should, in turn, result in an equivalent step down in the hurdle rate of return required by equity investors. Now, all else being equal, for the implied hurdle rate to reduce, equity prices must increase.
We have seen this latter dynamic in bond prices over the last 12 to 18 months. As interest rates have fallen, bond prices have delivered very strong double-digit capital gains. Equities should be no different – and indeed, higher-growth earnings streams should be even more sensitive to reductions in hurdle rates, than lower growth earnings streams.
One logical investment approach in such a new lower-for-longer interest rate environment would be to buy earnings streams which are growing sustainably. That is, earnings growth which should materialise under nearly all economic environments that play out. Take the French company Vivendi, for example. It owns the largest record label in the world: Universal Music Group (UMG). UMG earns a royalty from subscription fees paid by consumers to music streaming platforms, such as Apple Music, Spotify and others. Therefore, as more consumers adopt digital music streaming all around the world, UMG’s revenues and earnings grow. And this dynamic is structural with a long runway still ahead. Consider that only around 13% of adults in the US subscribe to a paid digital streaming service. In countries like France, Germany and the UK today, this penetration rate is less than 10%. And in in China today it’s around 1%. These low penetration rates underwrite structural growth in global digital streaming revenues of around 20% per annum, well into the next decade.
In a low interest rate world, growth becomes increasingly valuable to investors. But what drives rates low in the first instance, is tied to lower economic growth. Therefore, as bears will argue, low rates are a warning sign for equities. But a strategy which focuses on owning earnings streams which are growing sustainably, should benefit from the magnification in value of the growth, without the risk of the growth becoming impaired.
Montaka’s funds own shares in Vivendi.