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Quarterly notes on investing: Q4 2019

10 March 2020

Capital Generation Partners

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Negative Rates: What’s the Problem?

In Denmark, you get paid by the bank to borrow money to buy a house. How cool is that? In practice, you still make repayments but your total repayments are less than the original loan: still pretty cool. These are negative interest rates in the raw. Soon to become part of $17trillion or so of debt that attracts negative rates: basically, the Eurozone and Japanese bond markets.

It is all rather strange. A market-based economy should not have a market – for debt capital – that has no positive price. While it is great to borrow at negative rates, it is demoralising to save at negative rates. Until now, capital that was lent without an interest rate, or a negative rate, was typically a gift or a public policy decision.

How low can negative rates go? All the while that there are still actual notes and coins cash, there should be a floor to negative rates. After all, if by depositing money at the bank, you are guaranteed that it is shrunk by negative rates, you will keep more of it at home. The lower negative rates go, the more cash you will choose to hold, the more money will be withdrawn from banks and the more the pressure on the banks to raise interest rates to bring cash back. Well, that’s the conventional theory at least.

Conspiracy theorists thus worry that governments are eager to eliminate cash so that they can then impose any negative rate they like. But that would be quite a legislative feat and, anyway, there is gold, the crypto currencies, and, who knows, maybe conch shells will make a comeback. Indeed, the existence of, and discussion of, alternatives to cash tells us that negative interest rates currently do not make sense because people don’t believe in them.

The question then becomes why are they there? One answer is that whilst nominal rates are negative, real rates are actually positive and we are simply mis-measuring inflation. We think inflation is zero or slightly positive. In fact, it is sharply negative. The purchasing power of our cash is soaring because of all the new things we can do with technology. It used to be easy to measure technology. If this year’s calculator was twice as fast as last year’s at half the price, we knew that the effective price of the calculator had fallen 75%. Measuring the impact this year of doing faster and better things we were doing last year is easy.

Measuring the impact of something that is new is hard. How has social media reduced the cost and increased the value of an activity – vital for inflation measuring? How can you assess the impact of swiping right on Tinder on the cost (surely lower) and efficiency (presumably better, or so a friend tells me) of dating compared to Friday and Saturday nights spent going to new bars, restaurants and clubs in order to access new reproductive talent? There has been a massive, unmeasured, shift in standards of living – the phenomenon of negative rates is partly about this moving through our system.

That is the technology bit. Another, related, answer is that we have also misunderstood globalisation’s impact on monetary policy. Central banks worry about national capacity: are we below, at, or above national capacity. But they miss the point that capacity ebbs and flows across borders rendering measures of national capacity too narrow or, at worst, entirely moot. Interest rates were in fact too high for too long given global capacity and the current period of low to negative rates is simply righting the balance.

Another explanation is that negative rates arise from the saving of recently minted middle income consumers in Emerging Markets who, anticipating old age in countries that have underdeveloped insurance and social welfare provision, are willing to accept low or negative returns on their savings because they see them as paying insurance premia.

There are other explanations too – the market factoring in the GDP negative impact of climate change for example. But whatever the reason, negative rates will, if they persist, kill capitalism, which depends on being rewarded for investing capital not hoarding or borrowing it. And with this threat to capitalism we also see a threat to the existing social, economic and political settlement. Capitalism holds that inequality is an outcome of fair competition in a reasonably open, free market and although we must protect those less fortunate and talented, there is a legitimate reason for inequality of outcome. If, however, the market and the outcomes of the market are very dependent on governmental activity, in this case monetary, how can inequality be seen simply as a regrettable outcome of a free market? It is instead the pernicious outcome of an artificial, government-created market, and something that government can justifiably “remedy”.

In the post war Keynesian heyday, fiscal policy shaped economic outcomes in many Western countries. And with it went a general disposition to redistribution, fairness and equality. Keynesianism faltered and ushered the more laissez faire era of globalisation built on a hands-off monetarism that more or less cared about price stability with a nod to employment. We may have lost gold but we got reasonably robust fiat money. Our world now has less robust fiat money, negative interest rates, a Japanese government owning not just chunks of its bond market but also its equity market. It is hard to continue to maintain that governments just need to roll with the outcomes of the market. Why don’t they just change those outcomes?

 

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In this topsy turvy world, savers are punished and borrowers are rewarded. So the news that some ETFs are moving to negative fees ought to be a welcome ray of sunshine. Instead of charging a fee for the service they deliver, ETF providers are moving to low or zero management fees and in some cases, a negative fee. Salt Financial applies a 34 basis points fee waiver on the fund’s 29 basis points management charge meaning customers will receive $5 for every $10,000 they invest, without factoring in investment returns. A small harvest, but one that reverses the usual state of affairs in which customers pay for the service being provided. 

But we should not view this as a reversal in the direction of travel of the cost of capital. ETF providers are engaged in a war for market share and are slashing management fees as a way to attract clients. This is not because the cost of capital in the ETF market is fundamentally different to the cost of capital elsewhere. Rather it is because ETFs are also engaged in an activity which is, at the margin, more profitable than boring old money management for retail clients – namely securities lending. Blackrock, for example, earned $597m from securities lending in 2017 and whilst the majority of this gain was allocated to the funds, to the benefit of customers, BlackRock itself retained 37.5% of that profit. No wonder then that other ETF providers are on the hunt for market share – it’s not the retail clients they want but the ability to become serious players in the $9.2bn securities lending sector.  

The risks to investors are worth exploring. Few ETF investors will have the skill to work out whether their ETF is appraising the risk of securities lending appropriately. Aside from the obvious counterparty risk, there is a frequent mismatch between securities lent and collateral received. Banks are increasingly looking to reduce their balance sheet of risky securities and so are offering these up as collateral to ETFs in return for the loan of the ETF’s more desirable securities. All fine until a market correction happens and the riskier securities suddenly look poor recompense for the quality securities loaned by the ETF.

Meanwhile, ETFs can make a decent profit lending hedge funds the sort of securities that hedge funds are interested in shorting. Which must mean that some ETFs are tilted towards serving this market with all the risk and conflict of interest that that entails. How many ETF investors would understand that their holdings are being shorted, with the active assistance of the ETF provider?

Finally, there is the risk of fund failure. The current ETF fee war is a winner-takes-all gambit and, inevitably, there are already casualties. Those without the heft to sustain themselves will fail and indeed 2019 has seen the worst ever rate of ETF failures with 58 funds being liquidated in the six months to June. 

Far be it from CapGen to demand that ETFs increase their fees. Capitalism (for as long as we still have it) promises us price transparency and price competition and we welcome the sort of competition that reduces fees to their lowest sustainable level. Securities lending plays a valuable role in keeping costs down. But when costs appear to be lower than sustainable for the service being provided, we must ask whether profit is being made elsewhere and if it is, whether that profit centre is in line with our risk appetite.

 

Snapshot for the quarter

  • July marked the point at which the USA attained its longest period of economic expansion on record – a period which has endured since 2009.
  • However, the USA has also managed a record 13 years without achieving 3% real GDP growth over the year. The previous record stretch – 1929-1933 – was just four years long.

 

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