Interest Rates Lower Than the Belly of a Snake
Low interest rates are the spawning ground for a number of different economic shifts and upheavals. The more obvious examples are the impact on savers, largely those pensioners who may have been relying on rates in the mid single digits or higher. Many retirees may have thought they had enough savings to carry them through retirement and they are now finding that they are taking big bites out of their principle just to support their living expenses. The dawning realization that people are living much longer and more productive lives is giving pause to consider whether they can go the distance on what they have without taking on additional risk.
The institutional victims include pension funds, insurance companies, and banks. The repercussions are reverberating across the economic landscape and we will all feel the effects in one way or another. Slithering reptiles are a nice option compared to interest rates that are lower than the belly of a snake.
Low Rates, High Pressure
Canada is among the best in the G7 for debt to GDP, including unfunded pension liabilities. 40% of the states in the US are operating under-funded pension plans which are below the acceptable funding threshold of 70%. Expect these conditions to be worse for private sector pension plans not benefiting from the power of taxation. Imagine if you will, how every one of these former employees with a defined benefit pension plan is now a liability that either a tax payer or a shareholder is paying for.
When lots of people are working and a relatively smaller group is collecting benefits, a funding threshold of 70% may have been manageable. Today we have a demographic wave going through that will absorb any buffer created by new contributions. Some people believe the funding threshold ought to be 80% or 100%. Regardless of where you draw the line, there is going to be pressure when combining the demographic shift of more pensioners living longer, fewer contributors, stubbornly low interest rates and the necessity to hold larger portions of the pension plan in fixed income.
Banks and insurance companies have their own form of misery and it is compounded by stronger regulation. Reserve requirements have been re-evaluated and increased after stress testing in the wake of the global financial crisis of 2008. Reserves are tied to interest sensitive assets, which are yielding next to nothing. Even with modest lending defaults and operating costs, the result is razor thin profit margins on loans at the prime rate. It doesn’t pay to lend. The intended stimulus is not getting money into the system. The pressure is global in scope as there are at least a half dozen countries around the world with negative interest rates on deposits which provide little incentive to provide loans.
Over the past 50 years, insurer’s made what were thought to be conservative interest rate assumptions to calculate product prices and today they are hard pressed to get the targeted returns needed to remain profitable. Increasing prices for products and services is not nearly as easy to do in a world which is largely commoditized. Make no mistake about it, insurance companies are also under pressure.
The wealth management industry is under pressure because a low yield environment makes it harder to justify fees when the cost of management is consuming a larger portion of the yield. The pressure to perform is likely to produce some rather frustrating outcomes. Risk is increasing as more money chases higher yielding assets. Similar conditions in the past caused one investor to suggest more money has been lost chasing yield than at the end of a gun.
There will always be a solution of one sort or another, a next rabbit to pull from the hat, so survival is not the concern. The concern is safely funding the lifestyle needs and dreams of my clients. How do we make money owning nice big strong businesses when businesses have to take large chunks of their operating income to pay down pension liabilities? Or when profits are dependant on financial engineering and leverage to pay off higher cost debt or to complete share buy-backs?
The skinny returns being offered to investors on our beloved businesses and financial institutions are not without risk. In fact, risk is very much alive and well and risk is increasing as markets edge higher. The difference today is that we used to be sufficiently rewarded for taking on investment risk. A private business owner would hardly get out of bed to invest in something that did not promise returns of 15-20% or more. We are in the world of relative investing, where relative to the other options we buy where “there is no alternative”, (TINA).
The challenge with relatively good performance is that its hard to buy groceries with it when the performance is negative. We need absolute performance numbers and many people require returns that are in excess of those widely available to investors today. Above all, we need safety of capital. Today we have increasing numbers of dollars chasing the TINA trade and it works until it doesn’t work anymore. Owning a poor quality asset at a cheap price is similar to picking up cigar butts from the sidewalk because you get a puff for free!
By now you may be wondering what to do when interest rates are flat and investment returns are skinny with increasing risk. There are no easy answers. Advice is going to be a big differentiator, more so than when turkeys are flying in a windstorm. Here is my perspective.
First of all, own small portfolios, each with high conviction in a tightly selected small number of securities. Simply stated, many great businesses are not worth owning at these prices. Invest with managers who will operate with minimal portfolio turnover, as evidence of their conviction, and manage portfolio trading expenses and the resulting taxes in non-registered accounts. We don’t mind waiting for a mispriced business to be discovered, and we like to be paid to wait with dividends.
Favor managers who will accumulate cash waiting for opportunities to emerge. Investors who paid too much for Coke near the turn of the century waited about 16 years for the underlying value to catch up to the price they paid. If those same investors held onto their cash instead, surely they would have been provided with a more compelling opportunity to buy at a discount. This proves the TINA trade is flawed logic, a form of group think; lemming like behavior. There is always an alternative.
Value based investing has not lost its appeal, especially when the relative investing crowd starts throwing money around. Finding value is the challenge. Many of the best value investors are satisfied with finding one or two good ideas per year. The TINA trade is chasing dividends, and the bigger the companies the better. Smaller companies are getting less attention, their prices are offering a margin of safety, and the upside potential is sufficient enough to justify the investment risk. Small companies are typically less liquid, so we can spread risk by increasing the number of funds we hold, choosing funds that are not burdened with large positions in a single stock, and increasing our cash position.
Those are my big ideas for the conditions we are facing today. We have taken the initiative over the summer months to complete our research and we are ready to take action toward finding new value in less followed businesses and preparing for opportunities that are sure to follow.
regulation | low interest rates | pensioners | under-funded pension plans | pressure | relative performance | advice | value based investing | margin of safety | big ideas