“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influenc, are usually the slaves of some defunct economist.” – J. M. Keynes
In response to the ongoing financial crisis resulting from debt overhang in developed economies, central banks across the world are treading the unknown with some rather unconventional monetary policies. This, in turn, is leading to sustained expectations of negative real risk-free interest rates in most parts of world.
Conventional wisdom states that negative real rates are good for proxies of real assets, mainly equities. This conventional wisdom is also acknowledged by the San Francisco Fed when it says, “Lower real rates also make common stocks and other such investments more attractive than bonds and other debt instruments; as a result, common stock prices tend to rise. Households with stocks in their portfolios find that the value of their holdings is higher, and this increase in wealth makes them willing to spend more. Higher stock prices also make it more attractive for businesses to invest in plant and equipment by issuing stock.”
We argue here that the conventional wisdom has a major flaw, as it ignores agency problem in listed firms. Many of the listed firms are de-facto controlled by either a small group of shareholders or by the management. Although, it is legally and academically assumed that the controllers of firms will act in good faith to maximize wealth for all shareholders, the reality is different. Most market observers can state innumerable instances of controlling shareholders (managers) trying to direct wealth away from non-controlling shareholders of the firm, to the extent it is legally permitted or practically possible.
Hence, when the expectations of negative real rates arise in the minds of controlling shareholders of continuously successful businesses, it is all but rational for them to maximize their wealth by moving capital structure in favor of debt. They would prefer to use cash available with the company for stock buybacks and, in the extreme, when there are no new capex plans, it would make sense for controlling shareholders to finance the buyback by issue of new debt. This behavior is rational response to the fact that equity returns are real positive returns for continuously successful businesses.
Now, it is important to note that expectations of sustained periods of negative real rates arise during the periods of extreme economic uncertainty. It would be interesting to see how the firms where controlling shareholders are not sure of continued success in the face of extreme economic uncertainty, would respond to expectations of negative real rates. Since the management is not sure of producing positive returns in the first place, they are indifferent between debt or equity; or in the worst case, they would prefer more equity compared to debt in order to reduce risk of bankruptcy of the firm.
Thus, a period of sustained negative real rates would potentially create perverse incentives in equity markets, where good firms will seek delisting or reduced float; while bad firms will seek to raise further capital in the market. This will lead to deterioration in the quality of investible universe for equity investors, making equities less attractive than before.
The earlier the asset allocators get rid of the notion of sustained outperformance of equity markets during periods of negative rates and keep an eye on the potential deterioration in quality of investible equity universe, the earlier they would free themselves from the yoke of “slavery of defunct economists”.