One of the best things that ever happened to me was my grandfather gave me $5,000 when I was born. My dad then invested that money conservatively, in bonds, and by the time I was off to college, I had enough money saved up to pay for my education. I graduated with no debt. That was a huge benefit to me starting my life as an adult.
Think about that for a moment. Negative interest rates!
I still can’t get my head around it.
I’m not an economist and I don’t live in an ivory tower. I live in the real world. I never thought negative interest rates were even possible.
It doesn’t make sense in the real world.
Central bankers, however, live in a bizarro world where they can create policies that don’t make sense. Those policies likely have unintended consequences. And like with any untested experiment, we won’t know the extent of those consequences until after the fact.
Imagine treating the general public with a new medicine without testing the side effects first.
Let’s look at some of those consequences.
The biggest one is the misallocation of capital. I have talked in the past about how acquisition activity is through the roof. However, acquisitions historically add little value and often muddy up the earnings quality of the acquirer. But because interest rates are so low, companies don’t have as many means to allocate their cash.
So, they’re amping up their acquisitions, essentially overpaying to grow. This poses problems for investors as it makes it more difficult to value a company that is bolted together with acquisitions.
Beyond acquisitions, low interest rates have also led companies to spend money to buy back shares. Revenue growth has been anemic. Margins peaked a couple of quarters ago. Companies have crammed down their tax rate as much as possible. So, the only way to grow earnings per share is by lowering the share count.
But, those buybacks haven’t bought much:
Since 2011, companies that have bought back the most stock have dramatically lagged both large-cap stocks and companies that bought no stock back. The ones that didn’t participate in these shenanigans, as you can tell, performed the best.
A better use of capital would be spending money on new revenue-producing products and services. But, interestingly, companies that have higher levels of capital expenditures, compared to cash on the balance sheet, have also lagged significantly in performance.
I don’t have a good explanation for this. Companies that are putting money back into their business should be outperforming the market. It’s the $1 trillion question. It’s just a sign of the bizarro world we live in.
Another unintended consequence of these policies is that is that it basically encourages banks to go out and make as many loans as they can. It’s forcing money to be lent to risky borrowers, presumably to fight the deflationary environment that’s going on globally.
I don’t see how that can possibly end well. These aren’t powers you can fight back with a stick.
The scariest thing though is that no one knows how this is all going to end. I have a lot of respect for former Dallas Federal Reserve President Richard Fisher. He sums it all up pretty well in a speech he gave in 2012:
“I believe that with each program we undertake to venture further in that direction (quantitative easing), we are sailing deeper into uncharted waters.
We are blessed at the Fed with sophisticated econometric models and superb analysts. We can easily conjure up plausible theories as to what we will do when it comes to our next tack or eventually reversing course.
The truth, however, is that nobody on the committee … really knows what is holding back the economy.
Nobody really knows what will work to get the economy back on course.
And nobody—in fact, no central bank anywhere on the planet—has the experience of successfully navigating a return home from the place in which we now find ourselves.
No central bank—not, at least, the Federal Reserve—has ever been on this cruise before.”
We are truly in uncharted territory. These people are smart, and clearly educated, but they’re doing something that’s never been done before. No one knows exactly what’s going to happen when they try to unwind it, but it stands to reason that it won’t be pretty.
John Del Vecchio
Editor, Forensic Investor