Co-authors: Ashok (Ash) Kamath & Nilkanth (Neel) Kulkarni
The US Fed has exhausted its playbook on supply side stimulus and is well on the road for negative growth and deflationary trend. Global Central banks of the world took a page out of this Fed Reserve playbook and went a step further to introduce negative interest rates. Unless the US Fed changes the game by introducing a new playbook on demand side stimulus, US economy is at risk. Barring a new US Fed Reserve playbook, let’s look at the what this means for the US economy, investors and common man
- Effect on the US economy:
It is only a question of time before the Fed Reserve is forced to negative interest rates as the other economies benefit from buying GDP growth from the US. The impacts will be deep and swift over 2016, 2017 and maybe beyond.
- Capital Inflow: The US has seen capital inflows before from Japan in 70’s, Middle East in the 80’s, Koreans in the 90’s and handled it well. However this time the unprecedented scale of inflows from all regions at the same time has the potential to overwhelm the US Treasury markets .Irrespective of the Fed policies the market demand for treasury bonds will push treasury yields into negative territory.
- Currency: The US dollar will keep rising against all other currencies to new highs and exports will drop. US Capital intensive industry sector will face head winds as pricing power and margins decrease, existing debt servicing ratios will increase. The US Federal government and states will face debt servicing challenges.
- Political Risk: US economy will be in deflationary mode. Corporations will see drop in growth, revenues and earnings quarter over quarter and will cut capital budgets, curtail dividends, employment, expenses and production. Retirees and fixed income segment of the US population dependent on interest, dividend income will get restive.
- Market Risk: The US stock markets will drop at least 25%. Corporate revenue and earnings will slide especially for the corporations with dependencies on global markets. In turn this will drive down their stocks. Multiple sectors will be affected with some exception such as Real Estate sector. Real Estate will benefit significantly given a combination of very low long term interest rates and easy credit building a foundation for a new bubble in the future. The stock markets will get leaner as more corporations delist, go private or reduce stock in float through buybacks.
2. Effect on US Investors
We have broadly divided the investors into two categories as Conservative and Speculative. Typically the conservative investors would include Pension funds, fixed income, Insurance companies, Retirees etc. The Speculative investors include traders, millennials, wealthy investors, Private equity funds, Hedge funds etc.
- Conservative investors: initially will try to rebalance their portfolio towards Treasuries and AAA bonds as a knee jerk reaction to the volatility in the market. As the conservative investors adjust to the new circumstances they will subsequently move to the safe dividend paying stocks and reduce their exposure to international markets and technology stocks. Retail investors will stop savings in 401K account, education accounts, pension account etc. as negative interest will change the philosophy and thinking from savings to consumption.
- Speculative Investors: on the other hand will try to take advantage of the situation and pile into these very sectors seeing opportunities based on fanciful risk reward calculations. Speculative investors will have a wonderful time as the volatility in stocks and bonds will facilitate wild swings in stocks, commodities, currencies and debt markets. Forex traders will also trend to gain due to the speculative currency market.
3. Effect on US Common Man
As other currencies and commodities depreciate against US dollar the US consumers will benefit. Even though income inequality will increase it will be offset by declining cost of living adjustments and deflation in consumer prices. It will not be farfetched to predict that consumer incentives to purchase durable goods will exceed anything seen in history.
- Consumer segment of retirees, near retirement and those on fixed income will see drop in income due to negative interest rates.
- Consumers will stop saving in retirement, long term care and education accounts as saving will be akin to losing money.
- Consumers will quickly figure out that borrowing and current spend at negative rates is better than spend from savings.
- Drive changes in consumer banking as the Fed Reserve will mandate changes to staunch the flow of withdrawals by limiting amount and frequency of transactions.
- Consumers will be forced into banking transactions by mandating that consumer pay bills over a nominal amount through their electronic transfers thereby providing the banks to add a negative rate amount to each transaction.
- Consumer credit will see monumental changes. Demand for subprime borrowers will be greater than prime borrowers. The rating calculation for FICO scores may switch from available credit to credit used.
- For consumers the concept of cash currency will change as smaller denomination tenders increase while the Fed Reserve will reduce $100 currency bills in circulation.
Conclusions: There is an old adage “what goes around comes around”. The Fed Reserve QE program conceived in panic of the 2008 financial crisis has led to US buying GDP growth from other global regions through a combination of weak dollar and easy liquidity. For the last 8 years the QE effect has stimulated international markets for American companies in terms of profits and growth at the expense of US domestic growth.
With the introduction of negative interest rates the income and wealth disparity in the US will exacerbate. This will be balanced and cushioned by cost of living adjustments (COLA) due to deflation and will reduce political risk. Saving degradation and net wealth distribution will increase as the overall US consumers will stop saving and start spending more. The US National Debt will increase due to profligate borrow and spend policy of the US Government, in a desperate attempt to simulate GDP growth..
The greatest paradigm shift will be seen in the financial sector as “Too big to fail” US banks will now be “Too big to support”. Economic shifts and the resulting imbalance will create systemic risk. Extreme stress will start and spread swiftly across all sectors of the US economy.