The Hidden Dangers Of Low Interest Rates

by: Jesse Moore

Summary

Zero and negative interest rate policies have resulted excessive share buybacks.

Large companies that don't need capital are borrowing money as a way of increasing earnings per share.

As the capital available for corporations dwindles, credit spreads will start to widen.

Debt to cash flow ratios are a red herring of increasing corporate defaults.

The economy is set to fall into recession regardless of the direction interest rates move.

As standard economics goes, the lower the interest rates in the economy, the higher the flow of capital to markets. Countries around the globe have experimented with Negative Interest Rate Policies (NIRP) and Zero Interest Rate Policies (ZIRP). Among this we have seen a continually faltering economy, struggling growth and an anemic private sector. In this article, I explore the argument that there becomes an inflection point where interest rates get too low and have the opposite effect than standard economic policy would suggest.

From the banks perspective, it is simple. The lower the interest rate that the federal bank provides on deposits, the more likely banks are to lend that money out.

Low-Interest Rates For Businesses

From a single company's view, low-interest rates are good. However, reduced interest rates result in cheap debt accumulation by firms that don't necessarily need it. This means that the debt supply dwindles, and more debt holders are seeking fewer lenders. Eventually, this pushes credit spreads up, which we are starting to see now.

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Source : FRED

Deflationary Lending Environment

As businesses in deflationary ZIRP and NIRP environments discover, they can not gain any reasonable risk-free (or risk reduced) return for their capital. Holding the money results in depreciation in NIRP, and thus, companies look to reduce the amount of money they are holding at a given time. Public companies struggle to invest excess cash with any reasonable risk/return. Therefore, cash held on the balance sheet decreases in value every year. Most management teams are incentivized on increasing EPS, share price rises, or similar mixes, and thus have every incentive to prevent this from happening. Here we bring on the share buybacks.

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Source : FactSet

Share Buybacks As The Only Way To Increase EPS

In the right environment, share buybacks are a tax-efficient way of returning money to shareholders. It increases EPS, and increases the value of each share, allowing investors to choose when/if they need the money by selling their shares. But when companies move to load up on cheap debt to complete share buybacks as the only way of increasing EPS, it creates a dangerous mix. It has the initial effect of increasing the risk of the sector as a whole as companies remove cash and increase debt; this happens invisibly to most investors as EPS creeps up. Elevated share prices follow the "increasing earnings," despite the fact that companies are doing little in the way of long-term operational changes and much in the way of short-term financial engineering. These direct effects run in a self-reinforcing circle, more managers are forced to do what their counterparts are doing, more debt is raised by companies that don't need it, and new companies are shut off to capital without taking on very high-interest rates, burdensome covenants, and onerous terms.

"Interest rates at near zero have increasingly prompted companies flush with cash to issue debt to fund share buybacks. Apple Inc, for instance, has issued $23.6 billion in debt this year despite having more than $200 billion in cash" - Reuters.com

Danger Ahead With Debt To Cash Flow Ratios

Large scale share buybacks aren't seen in debt-equity comparisons in the short term. The increased EPS often increases the share price and result in a net breakeven on the balance sheet, leading some to argue that debt-equity ratios are not obscene. However, when share prices begin to drop as investors realize that companies can not increase earnings through operational investments and changes, those debts to equity ratios start to look strained in a hurry. One merely needs to glance across the market to see debt to cash flow ratios at all time highs.

"But while equity has kept up with debt, corporate cash flows haven't. At the end of second quarter, 62% of all companies had twice as much debt as cash flow from their operations, according to JPMorgan Chase. That's up from 31% in the first quarter of 2006." - Fortune.com

Technology Companies Draining Other Sectors

This effect is compounded by an issue in the technology industry. Where companies draw earnings from the economy toward technology services. While this area is good for the economy to an extent, an abundance of profits attracted to very large companies with very few employees results in a vast disparity of wealth in the market and the economy. This variation means fewer jobs per dollar of earnings for the economy. Replicate that across hundreds of tech companies in the future, and you have a monumental shift in the way the market works. As a result, GDP growth does not correlate with median wage growth, money accumulates within a smaller group, and the impoverished portion of the economy grows. It follows that we will see (and have seen) a drastic reduction in the velocity of money through the economy. After all, if wages don't rise, consumer confidence starts to dwindle, productivity drops, and the economy can run on a self-reinforcing pattern of deflation that can be near impossible to stop (see Japan). Perhaps this argument is akin to the Luddites, but for those in the generations exposed to the industrial revelation, it was a terrible time of adaptation. By many accounts it took more than two generations do adapt to the new world order. And, we may find ourselves going through a similar period.

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Source : FRED

Click to enlarge

Source : FRED

Conclusion

As credit spreads widen due to a decreasing availability of debt for higher risk ventures, we will start to see the corporate default rates increase. We have begun to see this now, although much of the cause to date is due to catastrophe in the commodity sector. As we go forward we will see the effect of excessively cheap debt start to hit other areas of the market as debt to cash flow ratios rise even higher. It is apparent that much of the economy outside the technology sector is struggling to boost output and earnings, and many of those companies are resorting to sharing buybacks to increase earnings per share as a result. Perhaps interest rates can be too low, for too long, and federal banks experimentation with NIRP, ZIRP, and Quantitative Easing are starting to cause undesirable outcomes. Now that we are in this situation, an increase in the interest rates will cause great pains for the economy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Many of the assumptions are opinion based or inferred based on available information. This article is not, and should not be considered as, financial advice or an accurate view for investment purposes.