PERSPECTIVE3-5 min to read

What do “lower for longer” interest rates mean for value investors?

Low interest rates have lengthened this economic cycle and encouraged risky investment behaviour.

08-15-2019
Business-Team-Investment-Entrepreneur-Trading-Concept

Authors

Nick Kirrage
Co-head Global Value Team

“Lower for longer” has been one of the rallying cries of this bull market cycle. Indeed, interest rates are not simply staying low; they have recently been cut again by the US Federal Reserve.

Why do low rates matter? If interest rates remain low, economic growth is stimulated, defaults are scarce, financing is easy and risk-taking is encouraged.

Signs of this can be seen today in many areas, from rising leverage in private equity buyouts, to rising overall debt levels and the growing popularity of so-called “covenant-lite” loans (i.e. loans issued with fewer restrictions on a borrower and fewer protections for the lender than is usual).

The chart below shows that the share of private equity deals with debt multiples of greater than seven times profits has risen to almost 40% of the total. Leveraged buyers expect the profits from their acquisition to be greater than the interest paid on the debt used to fund it. Clearly, when interest rates are low it is easier to afford debt repayments, but if rates were to rise then highly leveraged buyers could find they need higher profits to afford the repayments.

value-lbo-high-leverage

“Lower for longer” is even being overtaken by “lower forever”. Today, bond investors are prepared to give Austria money for the next 100 years for a nominal yield of 1%.

What very low interest rates have done is elongate this cycle. They have enabled businesses to stay afloat when they should have exited an industry. They have allowed start-ups to obtain funding at rates that enable the company to be economic, when higher rates would have revealed the business model to be unsustainable. So low rates have slowed the impact of the feedback mechanism of capitalism, but they have not negated the economic cycle entirely.

Unless you believe that the economic cycle no longer exists, that we are in a post-capitalist society and that the financial gravity of mean reversion has somehow been altered, value investing will remain a feature of the investing landscape.

Do rates need to rise for value to recover?

Value’s recovery is not based on interest rates rising or falling. The experience of value’s outperformance in Japan during a long period of low interest rates highlights this, as the chart below shows.

value-low-rates-japan

If not rates, then what else? We don’t claim to be able to predict when value might recover, or what might be the cause. But we can offer some possible scenarios.

Today, corporate earnings are not actually falling, but if forecasts for future earnings are falling then that might be the catalyst for the market to start focusing on corporate debt levels. At that point, those over-leveraged companies will quickly look like very risky investments. Of course, highly leveraged companies with the highest earnings-per-share (EPS) growth forecasts have the furthest to fall.

Nine years into a bull market, equity investors have to be aware of where valuations are in comparison to their historic average. Within this, the dislocation between value and growth is at an extreme. Just as stocks priced for perfection eventually disappoint, stocks trading at a discount to the fundamental value of their underlying businesses are unlikely to maintain that discount forever.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.

Authors

Nick Kirrage
Co-head Global Value Team

Topics

Equities
Global
Nick Kirrage
Interest rates
Income
Market views
Perspective

Please consider a fund's investment objectives, risks, charges and expenses carefully before investing. The Schroder mutual funds (the “Funds”) are distributed by The Hartford Funds, a member of FINRA. To obtain product risk and other information on any Schroders Fund, please click the following link. Read the prospectus carefully before investing. To obtain any further information call your financial advisor or call The Hartford Funds at 1-800-456-7526 for Individual Investors.  The Hartford Funds is not an affiliate of Schroders plc.

Schroder Investment Management North America Inc. (“SIMNA”) is an SEC registered investment adviser, CRD Number 105820, providing asset management products and services to clients in the US and registered as a Portfolio Manager with the securities regulatory authorities in Canada.  Schroder Fund Advisors LLC (“SFA”) is a wholly-owned subsidiary of SIMNA Inc. and is registered as a limited purpose broker-dealer with FINRA and as an Exempt Market Dealer with the securities regulatory authorities in Canada.  SFA markets certain investment vehicles for which other Schroders entities are investment advisers.”

For illustrative purposes only and does not constitute a recommendation to invest in the above-mentioned security/sector/country.

Schroders Capital is the private markets investment division of Schroders plc. Schroders Capital Management (US) Inc. (‘Schroders Capital US’) is registered as an investment adviser with the US Securities and Exchange Commission (SEC).It provides asset management products and services to clients in the United States and Canada.For more information, visit www.schroderscapital.com

SIMNA, SFA and Schroders Capital are wholly owned subsidiaries of Schroders plc.