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A message on negative interest

"There is so little demand for cash you have to pay someone to look after it for you"
March 24, 2016

The financial world is becoming steadily weirder—we’ve now reached a point where in Europe and Japan the central banks have set negative interest rates. This takes us through the looking glass: there is apparently so little demand for cash that you have to pay someone to look after it for you.

Admittedly, commercial banks are being charged only fractions of 1 per cent a year on the money they deposit with their central bank, but even so, this is a very striking state of affairs. I try to ignore macroeconomics when thinking about particular investments, because it is just too hard to work out how the chains of cause and effect operate. But faced with the onset of negative interest rates, I can’t help wondering if there’s a message for me as a DIY investor.

These negative interest rates represent an attempt to stop commercial banks hoarding money. In effect, they’re a penalty for holding a potentially productive resource.

The fact that some central banks feel the need to turn interest rates upside down suggests that a lot of companies do not want to borrow from banks at any price because they cannot see potential ways to invest for a return that would outstrip even their modest cost of capital. This in turn suggests gloom about future levels of demand and the amount of spare capacity in their industries.

At the same time, quite a number of the larger companies on the London Stock Exchange have frozen or reduced the amounts they pay to investors in dividends. This has been particularly marked among oil and mining companies, but it extends well beyond the resources sector. Historically, investors have prized companies that commit to increase their dividend each year as earnings rise: a so-called “progressive dividend policy.” Freezing or cutting it amounts to an admission by the board that they are unlikely to be able to sustain these increases.

Given that academic research has long-established that reinvested dividends make up a very large percentage of overall long-term returns from the stock market, the current situation reinforces my worry that, as a broad asset class, equities are likely to offer meagre returns for quite some time. Grantham, Mayo, Van Otterloo and Co (GMO), the American asset management company, recently updated its seven-year forecast of post-inflation returns from various asset classes: it now expects large-cap (large capitalisation) stocks in the United States to return minus 1.2 per cent a year through to 2023, high-quality stocks to return 0.2 per cent a year and small-caps to return 1.5 per cent a year. The only bright spot seems to be in emerging market shares, which GMO believes will return 4.5 per cent a year after inflation over the next seven years.

This suggests that investing in an index tracker in the markets I focus on is likely to be an uninspiring experience, and that active fund management may be due a renaissance. If my choice as a DIY investor is between tracking a market that is going nowhere and actively picking a small number of companies I believe will offer strong long-term growth, I’ll stick with what I’m doing.