Farewell to Cheap Capital

The impact of rising interest rates.

February 10, 2011

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672786_tissue_boxExcess savings have been singled out as the cause of various catastrophes. On the business front, corporations are hoarding their cash, rather than, as they did in the late 1990s, buying new technology. Beyond that, they’re faulted for not spending on new hires – to employ workers who as consumers are already satiated with products they probably don’t need.

And in some countries, those worker/consumers have gone deep into hock for that, though a global glut of savings made the financing terms easier for a time. Now consumers are rebuilding their balance sheets – which suggests a “New Normal” for companies in developed countries with revenues of much less than 100% of their 2007 peaks.

A McKinsey Global Institute study, “Farewell to Cheap Capital” offers some insights – a retrospect on the past three decades and a forecast for the next two.

“The recent bursting of the global credit bubble followed three decades in which capital became progressively cheaper and more readily available. Today, interest rates remain very low for several reasons, including economic weakness in developed economies, little demand for new credit by heavily indebted households and central bank monetary policies aimed at stimulating growth. Many people have come to believe that low interest rates now are the norm.”

Will low interest rates continue? Only if too much money is chasing too few returns. McKinsey suggests that some of that wave of money sloshing about will be absorbed by developing countries doing their own Canadian Railroad Trilogy: “new roads, ports, water and power systems, schools hospitals and other public infrastructure.” On the other hand, urbanizing populations will draw down their savings as they upgrade their housing, while aging populations in emerging markets will do the same as they retire.

As more money gets put to immediate practical use, cheap capital in search of merely nominal returns is going to demand higher ones. “The world” McKinsey speculates, “ may therefore be entering a new era in which the desire to invest exceeds the willingness to save, pushing real interest rates up.”

This could come as a shock, since, in the developed world, the ratio of investment to consumption has been in decline for 30 years – with a cumulative dollar value of $20 trillion (the combined GDP of the U.S. and Japan, for those keeping score at home.)

While Western countries have run down their infrastructure with consumer-friendly tax policies, the stock of savings is likely to decline as emerging markets put their bank accounts to home infrastructure – the biggest building projects, McKinsey suggests, since the Marshall Plan reconstruction of Europe and Japan in the 1940s.

One reason is that the “global savings glut” that was held responsible for keeping global interest rates lower than their long-term average was not really a savings glut – at least in mature economies. McKinsey instead suggests that it was a consequence of a reduced demand for capital – a demand reduction on the order of more than 20%. McKinsey attributes part of that to slower-than-expected GDP growth. Then there’s Moore’s law, whereby the chief capital goods, namely computer chips, become cheaper over time.

But now that is in reverse, as emerging economies struggle not to update, but to create new infrastructure, while at the same time encouraging a more balanced economy less dependent on exports as domestic consumption rises.

Even if developed market consumers are beginning to have net savings, those savings will not cancel out the reduction of savings in emerging markets. The consequence: with demands for capital investment rising, real interest rates will have to rise – to bridge an estimated $2.4 trillion gap.

“This gap between the world’s willingness to save and desire to invest will cause upward pressure on real interest rates and crowd out some investment,” McKinsey estimates. “In turn, this could constrain global GDP growth unless the global economy can achieve higher capital productivity.”

With a scarcity of capital, McKinsey suggests, companies will have to build “ties with other large pools of capital, such as sovereign wealth funds, pension funds and other financial institutions from high-saving companies.”

On the investor side, “any increase in interest rates could mean losses for bond holders. But over the longer term, higher real rates will enable investors to earn better returns from fixed-income investment than they could in the years of cheap capital. This will reverse the shift away from fixed-income instruments and deposits toward equities and alternative investments, other things being equal.”

Intriguingly, “For some companies, this fall in valuation could be partially offset by a reduction in the net present value of future pensions and other liabilities.”

Whether McKinsey’s prognostications come to realization, it’s always nice to see a silver lining.

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