Getting paid to borrow money: is that the future? So can money REALLY grow on trees?
As of early 2016, more than $7 Trillion bonds were trading around the world with a negative yield. Borrowers are getting paid to take on capital.
This trend is unprecedented, and it's getting worse. The cumulative amount of negative interest rate debt continues to soar thanks to central bank polices in Europe and Japan, and ironically, more countries are jumping on board.
In the face of a weakening economy, the Fed's stubborn agenda to raise rates may prove to be the catalyst for eventually needing to lower its own benchmark rate into negative territory.
After all, the quarterly operating earnings of the S&P 500 continue to decline year over year, and given negative earnings growth, the valuation multiple of (17.3X) is already stretched by historical norms. On top of that, it has been more than seven years since the market officially bottomed in March 2009, implying that another recession (or major stock market pullback) is lurking.
However, it's a catch 22.
An 18X P/EBIT multiple for the S&P 500 is really cheap if the Effective Federal Funds Rate (EFFR) stays at these levels. Now hear me out.
Today the yield on a 10 year US Treasury is 1.84%. Having the benchmark for the entire financial system this low has the potential to radically distort earnings and revenue multiples from traditional standards.
To make it simple, we'll turn the S&P 500 into a theoretical "Company X." If I buy Company X at a P/EBIT multiple of 18X I'm getting an operating earnings yield of 5.56% (1/18). In theory this earnings growth will compound and get reinvested into growing the business, but to be conservative, we'll assume the earnings stay flat.
Company X is trading at $100/share with $5.56 in operating earnings. In 10 years, I will have business that is still worth $100, and has $55.56 in the bank from those 10 years of earnings (assuming no growth). This $100 investment is now worth $155.56 in 10 years.
That same capital invested into 10 Year Treasuries will yield 1.84%. In other words that same $100 investment will be worth $120 in 10 years.
In this scenario, the S&P 500 (or Company X) at an 18X operating earnings multiple is a far more lucrative investment for the next decade relative to 10 Year Treasuries.
One could argue that the S&P 500 carries a risk premium to 10 Year Treasuries and therefore should offer a higher yield, but how much of a buffer is appropriate? How much more credit worthy is the debt ridden US Government when compared to the collection of the world's largest and most profitable corporations that is the S&P 500? In a toss up I'd go with the S&P 500, but nobody asked me.
During the Great Recession in 2008, the Fed lowered the EFFR by 500 basis points from the mid 5% range to essentially 0%. During the 2001 Tech Bubble crash, the Fed lowered the EFFR by a similar 500 basis points from ~6.5% to ~1.5%. Even if the Fed is able to lift the EFFR to 2.5% by the time the next recession hits, a 500 basis point drop still takes us to a -2.5% EFFR. In this scenario, the US will have officially adopted a Negative Interest Rate Policy (NIRP).
The current difference between the EFFR (0.37%) and the yield on 10 Year Treasuries (1.84%) is about 150 basis points. If this holds, at a negative -2.5% EFFR 10 Year Treasury notes will yield -1%.
Capital, like water, will flow to assets with the highest yields.
This is why negative interest rates are so scary. They have the potential to flip the entire financial system on its head.
Let's take a step back. What is Company X worth with 10 Year Treasuries at -1%?
Even if earnings growth is flat, at a P/EBIT multiple of 100X Company X is still mathematically undervalued. A 100X multiple equates to a 1% earnings yield. Earning 1% is infinitely better than earning -1%.
The more I try to rationalize how NIRP will impact equity valuations, the more irrational the answer becomes.
If the EFFR stays below 2% for a prolonged period of time, it's hard not to envision a world with much higher valuation multiples . The historical norm of a P/EBIT of ~15X for the S&P 500 may be long behind us.
It's a financial game of chicken. Either the Feds raises the EFFR and put increasing stress on the global financial system, or the Feds reverse course, holding the current 0-1% level. If the economy begins to destabilize, then both of these options will be out of the window, and the US will be faced with the sobering reality of another series of emergency drops in the EFFR to stimulate growth.
To sum it up, I'll quote Charlie Munger from the 2016 Berkshire Annual Shareholders Meeting when he was asked about negative rates;
"If you're not confused, you're not thinking about it correctly"