As savers and investors, we are coping with the distortions caused by low real interest rates. Interest rates have declined over the last 30 years to where savers are now subsidizing lenders. Although the Federal Reserve is working diligently to maintain a low interest rate environment until the economy regains its footing, we know intuitively that this cycle will reverse course.
A recent study by McKinsey has analyzed both the decline of real interest rates and the anticipated reversal. Over the last three decades, the cost of capital fell because there was more capital to invest than demand for it. This “savings glut” was not caused by excess savings, but by a fall off in the demand for capital. In fact, the global savings rate declined from 1970 through 2002, principally from reduced household savings in developed countries. But more importantly, global investment as a share of GDP fell even more and went from 26.1 percent to 20.8 percent in 2002. Total global investment from 1980 through 2008 averaged $700 billion a year less than it would have been had the investment rate of the 1970s persisted – a cumulative sum of $20 trillion. $20 trillion is nearly four times the size of all Asian account surpluses.
Investment rates soared after World War II as Japan and Europe rebuilt their shattered infrastructures. Real global GDP growth slowed in the 1960s. And, after declining to a low in 2002, it has begun to rise, reaching 23.7 percent in 2008. Although it dipped during the subsequent recession, McKinsey anticipates that under various scenarios, even slow global economic growth, investment will be approximately 25 percent of global GDP by 2030. This investment cycle is being fueled by growth in emerging markets. Across Asia, Latin America, Eastern Europe, Central Asia, and Africa, we are seeing increased investment in transportation systems, utilities, factories, skyscrapers, and housing. Due to the low level of capital in these areas, there will be considerable demand for additional investment in the decades ahead.
Coincident with the demand for capital, will be a change in the dynamic of global saving. China’s saving rate will likely decline as it rebalances its economy and domestic consumption rises. If China follows the historical experience of other countries - among them Japan, South Korea, and Taiwan - its national saving rate will decline as the country grows richer. It is likely that China, without limiting its need for capital, will reduce global saving by 1.8 percent of global GDP. On the other hand, increased saving in the United Kingdom and the United States, even if continued for the next 20 years, will add just 1 percent to global saving, not enough to offset the anticipated decline in China.
Demographic changes will impact saving, too. By 2030, the portion of the global population over 60 will be at record levels, affecting saving through either larger government deficits or lower household and corporate saving.
Despite declining savings until the recent recession, the demand for capital over the last 30 years declined even more. Real interest rates are at historic lows. Demand for capital is clearly increasing in the developing world, where saving is currently high. The need for capital will increase in emerging markets, even if growth there slows. With prosperity, saving as a percentage of GDP will decline. The implication is that real interest rates will rise. The gap between the supply of saving and the demand for capital will be apparent between 2020 and 2030. McKinsey is not forecasting when interest rates will rise nor by how much. They do think it could well be within 5 years, and historical normalized real rates would be 1.5 percent higher.
As we transition into an environment of more restricted and expensive capital, previously successful business models will have to adapt.
- Growth will be harder for companies whose sales were dependent on easily available credit. The financing arms of consumer durable companies will face profitability challenges as their cost of funding increases.
- Higher real interest rates will improve the economics of commercial and retail banking. The cost of retail funding typically rises less than lending rates. Because of the higher cost of bank loans, midsized companies will try to tap the capital markets.
- Short-term capital may not always be available in a capital constrained world. Despite the rise in long-term interest rates, companies (and, hopefully, regulators) will realize the benefit of matching their funding with the duration of their investments. This will reduce the trend of using short-term debt to finance capital projects.
- Hedge funds and private equity firms will not be able to use inexpensive leverage to achieve attractive returns. Success will depend more on unique insights and the ability to spot underdeveloped opportunities. Private equity firms, in particular, will rely more on operational management skills to increase a company’s value.
- Higher cost debt will encourage companies to seek more equity funding, relative to debt, than in the past. Equity underwriting and trading should increase.
- Due to the growth of saving and investment in the developing world, financial institutions of all types will seek to enhance their capabilities in emerging markets.
As the era of cheap capital closes, expect to see a reversal of an investment trend in place since the early 1980s. Falling interest rates encouraged investors to over-weight equities and alternative investments over fixed income instruments. Higher real interest rates will reduce the relative attractiveness of equities (a higher real discount rate will reduce the value of future cash flows) and curb investor risk taking in the search for yield.