A subscriber asks; How will negative rates affect business valuations?

Everything depends on interest rates. Those who can correctly predict their direction will be more effective at exploiting the opportunities in the asset markets.

Chris,

I am wondering what the [e]ffects negative rates will have on the entire finance industry.

Think about Discounted Cash Flow analysis and asset pricing models. What will borrowing costs look like?

So, you will have a cost to borrow but have no return for deposits?

The only way to make a return will be a cash flowing business or some investment vehicle that will allow part ownership in a cash flowing business.

Where is the opportunities in this? There must be some avenues to exploit beyond real estate.

A

Before we discuss the concept of negative rates, let’s review how asset prices respond to ever lower positive interest rates. This discussion can pertain to stocks, a vending machine business, rental real estate, or a hamburger franchise. Any business that generates cash for its owner can be valued by employing a discount rate.

With each incremental drop in prevailing interest rates, asset prices respond ever more strongly. This is based on the percentage change in rates rather than their total change.

As the world’s prevailing interest rate yield curve moves lower over time, asset price movements have been responding in a similar fashion to what we see in the chart above. It doesn’t matter whether we are pricing stocks, existing bonds, a retail franchise, real estate, or a medical or legal practice. When interest rates move lower, we need to plug in a lower discount rate in the discounted cash flow (DCF) formula. We can easily see that as rates move to zero, asset prices can explode.

It’s the percentage change in interest rates that determines the movement in asset prices. Thus, asset prices should respond as strongly when the DCF discount rate moves from 2% to 1% as they would with a drop from 8% to 4%, all other things being equal.

Imagine a scenario as rates here move closer to zero. We would need a protracted global war or a disease outbreak much worse than the Coronavirus to make asset prices fall in the face of zero rates. Even if the  underlying currency used in the asset pricing model is derided (e.g. USD), as long as interest rates remain low, asset prices should hold up when priced in that currency. Why is this? If interest rates in a particular currency are low, this would show that the currency is stable and viable for investment.

However, if that currency begins to fail, rates would rise to compensate for the currency risk. Thus, asset prices would fall as the currency fails. Once again, it comes down to the movement in prevailing rates. Some may think the US dollar is garbage, but with interest rates moving lower, the dollar is actually more valuable, and so will the prices of those assets denominated in the greenback.

All this runs counter to the logic in the alt-financial media. Those who have listened to the bears have basically rejected this simple line of reasoning. It’s hard to over come falling interest rates. The central banks and nation-state governments can make a lot of mistakes and the nations can run massive deficits, but if rates remain low, asset prices will move up higher.

Many types of businesses can also be valued using the capitalization rate (cap rate) and internal rate of return (IRR), although these two measures are primarily reserved for real estate and other tangible income-generating assets with finite holding periods. Although the cap rate is a static measure, we can determine whether an investment’s cap rate is attractive when compared to prevailing rates. The lower interest rates move, the lower the cap rate that investors will accept and the higher the asset’s price.

The IRR is similar to the DCF formula; as rates move lower, we can plug in lower discounting rates or accept lower returns, which will mean higher asset prices. I often use residential real estate as an example, since their asset values can be easily determined, measuring their rates of return are straightforward, and housing generally has a larger pool of potential buyers than say medical practices or 7-11’s.

I have been relaying these sobering realities to my audience for several years now, and have been warning that the central banks needed to guide rates lower over time. They have the power to make it a reality and there will be more to come.

Okay, so what about negative rates?

With negative rates, two things are certain;

  • Households will need to continue taking on more debt as asset prices move higher, and
  • The nation-state governments will need to continue to exert an ever greater control over most economic sectors as well as the financial and banking systems. As banks find it less profitable to lend, the governments and central banks will have to fill the vacuum and become guarantors/lenders of last resort. The governments and central banks will effectively ration out capital to the biggest and best funded.

So, how will asset prices respond to negative rates? I think we can draw some ideas based on Behavioral Economics, and from what I can see, the average person has been acclimated to the inevitable. While this is really uncharted territory, we can get a glimpse into the future by looking at the nations that already have been employing longer-term ZIRP or NIRP policies.

Switzerland and Denmark have been employing longer-term NIRP policies in an attempt to cheapen their currencies, and both have the highest household debt-to-GDP ratios in the world (outside of Australia). The Dutch also have negative longer-term yields and they are fourth.

It remains to be seen how the world will respond to a systemic regime of longer-dated negative rates. I have to believe that at first, we could initially see some serious dislocations in the capital markets. But as global investors grow accustomed to institutionalized negative yields, they will adjust and price assets accordingly. I have to conclude that asset prices, especially real estate, could move much higher than what most are willing to imagine.

Furthermore, this reader brings up a point about banks deposits with negative rates. As borrowing rates drop, banks will find it less profitable to lend to borrowers. Thus, I see the need for governments to exert ever more control over their credit markets. Think about what we have seen with the Fed’s ongoing intervention with overnight lending. This is just the shape of things to come. As rates drop, the government will continue to increase its intervention in most lending sectors.

Unfortunately, the only way to profit from NIRP policies is to invest in assets that generate cash, since money in the bank is quickly becoming a liability on the balance sheet. But at these relatively high asset price levels, many have been psychologically shut out.