Several factors, including population growth, income inequality, and low inflation, could keep a lid on rates over the next several years, says Morningstar's Bob Johnson.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With the Federal Reserve ending its quantitative easing program and talk of rate rises potentially in 2015, many investors are worried about the short-term outlook for rates. But what's more of the long-term outlook over the next five, 10, or 15 years. I'm here with Bob Johnson--he is our director of economic analysis--for his take.
Bob, thanks for joining me.
Bob Johnson: Thanks for having me today.
Glaser: Could you talk about some of the factors that you think about when trying to come up with a forecast, or the way that you think about what rates could look like over the long term?
Johnson: I've been talking for a long time about several factors. We've talked about population growth and demographics as the baby boomers move on as being things that could potentially limit rate growth. And I've also talked extensively about corporations perhaps needing less money than they used to, that our fastest-growing corporations are indeed the ones that are actually generating cash not using cash these days.
But today I want to talk a little bit about a paper by Larry Summers that talked about longer term in interest rates, six factors that may keep the real rate of return on bonds at a very low level for some time to come.
Glaser: Let's start with demographics then. Why will they keep rates low?
Johnson: On the demographics side, there is a very close correlation between population and GDP growth. And right now, our population growth had been running as high as 1.7% in the '50s and '60s, and now we are down to 0.7% on the way to a forecasted low of about 0.5%. So, that will tend to limit the growth in GDP. That means you need less working capital. It means businesses will need to invest less in equipment to grow because there won't be that much growth there.
Glaser: How about the demand for debt, though? How is that going to factor in here?
Johnson: I think, right now, from a corporate side, the demand for debt is really kind of diminished. What's happened is that the corporations have really built up strong balance sheets, they've got some great cash flows, and right now businesses are flush with cash. And going forward, the businesses that are growing the fastest are indeed, like the Googles (GOOGL) and so forth, the ones that actually generate cash the faster they grow. And even look at somebody like an Uber, who has no capital investment or limited capital investment in its market cap on that stock. It shows [what is happening] today and how people are investing without needing a lot of capital goods.
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Glaser: We've talked about income inequality and income distribution and how it could affect economic growth. How could it affect rates, though?
Johnson: That's a real interesting question. As we've gotten more and more income inequality, one of the things that becomes apparent is that if you're a high earner, you can save a considerable portion of your income--as much as half of your income, in the very high quintiles--but in the lower brackets, you spend every dime you own and maybe borrow a little. So, you spend a little bit more than you make.
And as we shift to more and more of the income going to the upper brackets, more and more of the money gets saved--and, again, that's more demand for bonds, which means lower rates. So, certainly, as we get this income inequality, it certainly raises the amount of savings, which lowers bond rates. And it's the same kind of factor in corporations, who have now built bombproof balance sheets with a lot of cash on their balance sheets that also pushes up the demand for bonds.
Glaser: Let's look at the impact of inflation in a few ways. First, just on capital goods themselves, a big driver potentially of people issuing debt, what's happened to the capital-good prices? What will that do to rates?
Johnson: That's an interesting phenomenon, and it presses on more than rates, maybe employment longer term or whatever, but one of the fascinating things that Larry Summers said in his paper and pointed out is that the price of capital goods over the last 30 years has risen at about 80% of the rate that general inflation has. In other words, capital goods have become cheaper relative to a lot of other goods in the economy than anything else. That's meant more capital investment and, as people make those investments, it has certainly kept down rates as well.
Glaser: And then just generally, if inflation remains lower than we've been expecting, could that lead to lower rates?
Johnson: A funny effect of our tax system, where we tax the inflation as well as your real income, is that the higher your inflation, the bigger spread you need above it to cover it because you're taxed on the inflation. And so, the lower the inflation, the less interest rate you might demand. The difference between the demanded rate is very dramatic between even a 3% and a 1% inflation rate.
Glaser: Finally, how are central banks' behaviors impacting rates, particularly with quantitative easing becoming more popular across the globe? What will that do to U.S. rates?
Johnson: Well, certainly, quantitative easing, which basically means the Fed bought bonds, certainly that's more demand for bonds, which again raises that demand and lowers interest rates. And that's actually what it's supposed to do, and those types of programs are spreading. We have seen Japan take them on and Europe contemplate going that direction as well. So, certainly, that's something, long term, keeping a lid on rates. But then what we've also seen, besides that, which probably can have its cyclical ups and downs, was more related to the late 1990s when we saw the Asian market collapses when countries couldn't get funds and were caught short and we had a lot of scrambling going on. Ever since then, the central banks in those countries have wanted to hold a lot of U.S. dollars, and that's certainly served to depress rates as well.
Glaser: Taking all of these factors together, what is your outlook for rates then over the next 20 years? Should we be worried about sharply higher rates from where we are now, or do you think that these are going to contribute to a much lower rate environment?
Johnson: I think we have to be very careful here. But I think, certainly, the Fed has kept the rates unusually low. And I think usually there's some type of spread over inflation, and I think it's going to be smaller than it has been; but rates still appear to me to be too low right now with the 10-year [Treasury] in the low 2s. I think it probably belongs somewhere around 3 or maybe even a little bit more than that. But longer term, everybody is saying, "Well, that's the first step and then we are going to go back to the days when we had 3% inflation and 6% bonds and 9% stock returns." But I don't think we're ever going to see those days again. I think that the underlying demographics now are going to limit growth and the demand for money to keep a permanent lid on long-term interest rates.
Glaser: Bob, I certainly appreciate your take today.
Johnson: Thank you.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
