Interest Rates to be Lower for Much Longer

Today, we live in an extraordinary environment as investors, with zero or negative interest rates in substantial parts of the developed world. However, this is the culmination of a story that has been unfolding for over 30 years, and the key question for investors is “what happens next”.

This is an edited extract from the presentation given by Andrew Clifford at the 2016 Platinum Asset Management Investor and Adviser Forums.

There are two possibilities, but neither of which we find realistic. The first is that rates will decline further into negative territory. This we think is improbable as already we see the preferable alternatives – gold, money in the safe, etc. A second possibility is that interest rates may bounce back towards where they have come from. We think this, too, is unlikely, and this commentary addresses why we may see rates stay “lower for much longer”, rather than simply the “lower for longer” that popular media takes to mean a slow exit from zero/negative rates. By “much longer”, we mean that investors could see a 10-15 year period of very low rates, and one which we think Australia will not be immune from.^[1] So for our core investor group, this is something that you should all be thinking carefully about.

The key investment impact of this prolonged period of rates trending down has been a long series of investment booms and ensuing busts, from the Japanese property bubble of the late 1980s through the “Asian Tigers” (and Asian crisis) of the 1990s, the tech bubble (and burst) in the 2000s, followed by the US (and other) housing booms (and GFC), China’s construction boom (a direct response to the GFC’s impact on its export industries) and the spill-over to resources (which is now fading), to the biotech bubble of the last two years. Closer to home we are still witnessing an ever-surging number of new apartments being built across our capital cities as part of an overall home building program, which on a per capita basis equals China’s 12.5 million starts that seem to concern every Sinophobe the world over today. Watch this space…

But it is the legacy of these booms that is part of the case for rates staying low. With high levels of indebtedness after such a binge, the system is more sensitive to rate increases than it has been historically. Secondly, there is significant excess capacity in all the areas that saw over-investment, which reduces the need for further activity. Finally, we are now faced with a paradox: The Economics 101 playbook followed by the central banks suggests that low rates would force consumption, but the reality is that low rates are forcing people to save more for longer to meet their financial goals, whether it is to buy a first home or to prepare for retirement. The concomitance of these factors is what makes it improbable for interest rates to rebound in the near future.       

Where we could see some surprises is the possibility of a return of inflation, which has been low for almost three decades. However, if we examine the three key drivers underlying the current low inflation environment, we would again argue that there is unlikely to be a reversal any time soon. Firstly, the opening up of trade with developing economies has provided and will continue to provide an enlarged pool of labour. Secondly, advancements in technology, particularly in terms of its impact on efficiency across a wide range of industries (think Uber, Airbnb, for example), have had and will continue to have a deflationary effect. Lastly, governments have been more disciplined with fiscal spending in recent years than in the profligate 1970s. It is this third factor that poses the biggest risk to the belief that we are in a “no-inflation” world. With the political cycle, however, one can expect that a change of direction will likely be well telegraphed.

It is useful to note that this kind of low-yield low-inflation environment is not without precedent. Jonathan Wilmot from Credit Suisse has produced some quality analysis on the two historical periods that most closely resemble the post-GFC era: the global recession in the 1890s and the Great Depression of the 1930s. The key lesson from these earlier episodes is that interest rates stayed low for 25 years from the start of the crisis. While economic systems have changed in significant ways since then, a similar pattern across the three periods can be observed in many metrics (Wilmot pointed to unemployment, industrial production, corporate earnings and credit issuance). So if our hypothesis is correct, it will not be the first time in economic history when interest rates stay low for an extended period.

The crucial cautionary note from these two earlier economic and financial crises is the anaemic returns from bonds and low returns from equities that prevailed during the period from around the 10^th to the 25^th year after each of these crises first began. A similar occurrence will likely come as a shock to today’s retirees who have seen both equities and bonds deliver handsomely since the depths of the GFC.

While we must be careful not to project another era onto today or to simplistically extrapolate from history, we do know that “history rhymes” and should always take lessons from our past errors.

With this in mind, the playbook that we, as an organisation, have familiarity with is the Japanese experience of high debt, weak banks and low growth. The Platinum Japan Fund, set up in 1998, nine years after the market peaked (today, we are nine years from 2007’s peak), delivered a compound return of nearly 15% per annum in a market where the benchmark index returned 1.5% p.a. We will be sharing with you a paper written by Clay Smolinski (Portfolio Manager of the Platinum Unhedged Fund and Co-Manager of the Platinum European Fund) on what we have learned from the Japanese market and how we can apply that in our portfolio today.

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.