Zero Interest Rates Equal Negative Returns

In the space of six hours nearly $60 billion was wiped out yesterday on the Aussie market.

At a rate of $10 billion per hour, it goes to show how fast you can lose your dough in a nervous market.

After the US markets finished in positive territory last night an uneasy calm should descend on the Aussie market today.

But for how long?

Are you nervous yet? Do you buy the dip? Do you take fight or flight?

Is this the beginning of The End of Australia?

What can the Fed do to steady the ship?

How will the Australian Government plug a $40, $50 or $57 billion budget black hole with an economy in low growth mode?

Will Glencore be able to raise enough capital or sell off enough assets to reduce its $50 billion debt load?

Lots of questions. But do really want to hear the answers? We are in the throes of a system of greed, denial and fraud. That system is destroying itself.

Is this a hyperbolic, apocalyptic and self-serving answer? Perhaps. But at least I’ve put my money where my mouth is. Cash and term deposits dominate my portfolio.

How many warnings do you need? Even the IMF, an organisation that wouldn’t know a bad economic number if it bit them on the backside, is talking down global growth prospects. The Fed is holding back on raising interest rates a lousy 0.25% because things are too delicate. China is manipulating its share market outright. In the US, 63% of publicly listed companies have not increased revenue forecasts.

The contraction is on and the deflationary forces are gaining the upper hand.

Zero interest rates have hastened our journey into the valley of financial death.

The grand plan after the GFC was to make capital so cheap that the debt dependent economic growth model would once again fire up.

Savers were forced to go in search of yield. Investment adviser client conversations went along the lines of ‘some of that tax free 8% Puerto Rican debt looks good’ or ‘perhaps we should invest in a Glencore bond to give you some extra return?’

This is from the Sydney Morning Herald on 11 September 2014 (emphasis is mine):

Glencore Australia Holdings announced its inaugural five-year benchmark issue with initial pricing guidance of about 140 basis points over the five-year swap rate, or about 4.85 per cent. The notes are expected to be rated Baa2 by Moody’s and BBB by Standard & Poor’s.

While the company did not put a number on the amount of capital it hopes to raise, five-year benchmark issues typically raise in the vicinity of $500 million.

The BBB credit rating is a notch above junk bond status. For this high risk, investors were willing to be paid a measly 1.4% above the five-year swap rate — which currently is around 2.4%. In total, a Glencore bond holder is today being paid 3.8%.

A quick google search found me a building society (covered by the Government Deposit Guarantee) paying 3.6% per annum for a five-year term deposit.

You can argue whether the deposit guarantee is going to be honoured or not in the event of a crisis. But I would sleep a hell of a lot better with my money in a Government Guaranteed building society than I would with a Glencore bond — especially for a wafer thin 0.2% difference in return.

Zero interest rates encouraged Governments, Corporates and, to a lesser degree, households worldwide to go on a post-GFC debt splurge.

China borrowed to build more infrastructure and factories. US corporates borrowed for share buybacks and oil drilling. Australians borrowed for homes and mines. Governments borrowed to meet the ballooning costs of welfare, healthcare and warfare.

All this debt was registered as economic activity. We were triumphantly told that the world has recovered from the worst financial crisis since The Great Depression. All Hail Ben and Janet. It was sickening to see G20 finance minister fawning over these Fed charlatans.

In truth, China was the lead elephant which all the others followed trunk tied to tail. China stayed upright and at a steady pace, pulling the others along with it.

But China has stumbled, and the others are following suit. Why? Because at some stage someone has to buy something with real money. China can build as many factories as it likes, but if there is falling demand, what’s the point? If there is no money then both parties — borrower and investor — may declare bankruptcy.

Zero interest rates might make debt cheaper, but they can adversely impact on investors… especially retiree incomes.

A great number of Western consumers are transitioning into retirement. Credit fuelled consumption days are but a distant memory for this demographic. They need to live off their savings.

In Australia the share market has been good to them. Fully franked dividends bolstered many a self-managed super fund. Hybrids have also been go-to investments for planners searching for higher income. In the US and Europe shares pay around 2%…well below the Aussie dividend rate. Therefore Municipal bonds, Corporate bonds and REITs (Real Estate Investment Trusts) have been the poison of choice for income hungry overseas investors.

While the sun is shining and the world is gearing up, these investments are a no-brainer. You literally need no brains. But what happens to investors and their advisers with no brains when the cycle turns from sunshine to storms?

You guessed it…they lose some or all of their money.

Not all these debt and quasi-debt offerings are going to be good for money. For example, will Glencore be able to pay pack its bond holders if the commodity cycle worsens? I doubt it. Will the US fracking companies that borrowed billions of dollars from investors in exchange for a few percentage points above a swap rate be able to pay if the Saudis keep producing oil at below their break-even price? Unlikely.

Zero interest rates spurred a debt spree that created headline economic activity…the crowd cheered.

Increased economic activity reassured investors in search of income that all was well, so they financed these corporate pie-in-the-sky and bonus rewarding schemes. The money-go-round was self-reinforcing.

After the RBA cut rates to 2% earlier this year, the cry from the investment industry was to get out of cash, because it was dead money. You should invest in companies paying fully franked dividends and hybrids. The share market nearly hit 6000 points. Where is the share market now? Below 5000 points. My money in the bank may not be earning much, but I still have 100 cents in my dollar.

The real problem with zero interest rates is that they’ve forced investors to take on risks they were clueless about.

As some of these trillions of dollars in dodgy corporate bonds start to default, income hungry investors will be capital starved.

Capital starved investors are going to be unable to spend or borrow. Welfare bills will increase. Health care costs (due to stress) will increase. Governments will go further into debt at a time when tax revenues are shrinking from declining economic activity. More corporate bonds will go bad. Eventually some Governments will raise their hands in defeat and also default.

Zero interest rates deliver negative returns. The size will depend on where you are invested. I suspect the majority of losses will fall into the 50–100% range.

Yes, our market may recover today and even tomorrow, but the negative forces created by seven years of zero interest rates are beginning to press in on all sides.

In due course the external forces will be too great for a system built on and reliant on debt to function. When that day arrives, sooner rather than later, if you have not already taken a defensive position, there will be zero you can do.


Vern Gowdie

Editor, Markets and Money

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Vern Gowdie has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia. He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

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