Negative Interest Rates Are Here

Adam Fischbaum's picture

Thursday, April 7, 2016 - 12:30pm

by Adam Fischbaum

Since the Financial Crisis of 2008, the United States, when compared to the rest of the world's monetary policy or economic performance, has been referred to as "the cleanest dirty shirt", "the prettiest woman in the ugly woman beauty contest", and, my personal favorite, "the tallest midget in the circus". The primary benchmark is the yield on U.S. Treasury bonds versus the sovereign bonds of other nations. 

Global government bond yields have been kept stubbornly low mainly due to the enormous supply of cash created by central bank quantitative easing (QE) in which central banks such as the Federal Reserve, the Bank of Japan (BOJ) or the European Central Bank (ECB) buy government bonds from financial institutions in hopes that the institutions will lend the cash to create demand at both the corporate and consumer level. In theory, increased consumption will stimulate business growth and lead to mild inflation. Interest rates will then gradually rise to head off rampant inflation keeping the business cycle steady while also rewarding investors with a little more return for their risk.

That hasn't happened. 

In fact, rates have done the opposite by continuing to fall. While the Fed in the United States has ended its QE policy and is looking toward a gradual normalization of interest rates, the ECB continues to crank the Euro spigot at full blast in order to spur the European economies that seem to be at a standstill with the exception of Germany. So central banks have taken it a step further. Their thinking is if interest rates are next to nothing or negative, investors will be forced into riskier assets such as stocks or private equity style investments in order to make any money. Thus economies are reflated spurring growth.

Yields on 10-year Japanese government bonds are -0.06%. Swiss 10-year bonds are yielding -0.40%. Investors are literally paying these governments to keep their money. Yields on 10-year German government bonds might as well be negative, at a paltry 0.10%. U.S. treasuries look like high yield bonds in comparison at around 1.7%. Not too bad considering, right? Wrong.

Here's the math: A 10-year treasury yields 1.7% today. The highest U.S. marginal tax bracket is 39.6%. After Federal incomes taxes (I won't even include state because it just gets too depressing), your effective rate is 1.0285%. The most recent national inflation rate according to data published by the government is 1% for the 12 month period ending February 26, 2016. While benign, inflation still leaves you with a whopping 0.0285% gain. That's close enough to negative for me. 

There is no need for Fed Chairman Janet Yellen to resort to negative interest rates. We're pretty much there.

How To Combat Low Interest Rates
So what do you do? You've got to find reasonably priced, high quality investments growing faster than inflation and yielding more than treasury rates. Plenty of investments can meet those criteria but the selection is the tricky part. Consistent operating histories and healthy business sectors are they key. Here are three ideas that will help you beat the negative yield blues.

Pfizer, Inc. (NYSE: PFE) -- The big pharma behemoth that brought smiles to the faces of middle aged men two decades ago, thanks to the "little blue pill", is attractively valued in relation to its big pharma peers. PFE shares trade at 30%+ discount on a forward P/E basis when compared to companies such as Eli Lilly (NYSE: LLY) and Bristol Myers (NYSE: BMY). The company beefed up its drug pipeline five years ago, acquiring King Pharmaceuticals, and is poised to profit from the continuing "aging population" trend. With the recent regulatory rejection of the company's proposed mega merger with Irish based Allergan PLC (NYSE: AGN) by the U.S. Department of the Treasury, shares have gotten a lift and are priced nicely at around $32.42 with a forward P/E of 14.1 and annual dividend yield of 3.7%.

Qualcomm, Inc. (Nasdaq: QCOM) -- Despite the TV pundit hand wringing over whether smartphone growth has peaked or not, global smartphone handset sales have advanced at a 7% clip annually since 2013 according to some analysts. While not a mind blowing, mid-teens, economic miracle style number that growth super bulls are inclined to tout, 7% compounded is a heck of a lot better than the forecast for domestic and global GDP growth. I examined this a few weeks ago

QCOM manufactures and licenses integrated circuit products (chipsets) and system software for use in mobile devices such as smartphone handsets and tablets. Currently, the company holds a massive 65% share in the LTE (long term evolution) baseband chipset market. That's what we would call a deep moat business. The company has grown sales at a 19% rate on average over the last 5 years with impressive net margins of 27% for the same period. Shares trade at around $50.15 with a cheap forward P/E of 12.25 and a 3.8% dividend yield.

Power Shares Global Listed Private Equity Portfolio (NYSE: PSP) -- Previously I touched on private equity (PE) investments as a risk category lower interest rates are pushing investors towards. PSP is a way for individual investors to get in on the action. This exchange traded fund holds shares of some of the largest publicly traded PE firms in the business. Included are well known names such as Apollo Global Management (NYSE: APO), Carlyle Group (NYSE: CG), and Leucadia National (NYSE: LUK). The second half of last year and the first quarter of this year battered private equity mainly due to fears of the Fed raising rates and weakness in the energy sector. This gives investors an opportunity to pick up shares of this ETF at an 18% discount to the 52-week high. Shares are priced at around $10.15 with an attractive 5.6% yield.

Risks To Consider: While rates are low, keep in mind that they are being held down both artificially and by the market. And while policy (artificial) may be able to be anticipated and reacted to, market forces can turn ugly quickly. However, the prospects of 10-year Treasury yields going from 1.7% to 5%, which would represent a 194% move, probably wouldn't happen overnight. I'm not saying it's impossible, but, at this stage, it's unlikely.  Also, if you're holding cash for a specified reason such as an emergency, purchase, etc., these investments are not a cash substitute. They are risk assets and must be treated as such.

Action To Take: If you're lucky enough to be earning 0.25% in a money market account, congratulations, after taxes and even mild inflation, you're negative. Yes. Markets and risk can be scary. But low to negative interest rates may stick around for a while and most people want to earn something on their money.

As a basket, these investments yield 4.35%. Not a fortune but, still, 155% more than a 10-year U.S. Treasury. The two stocks are high quality, deeply entrenched businesses with long, solid operating histories. The ETF gives investors diversified exposure to an asset class with little to no correlation to stocks or bonds providing income and growth potential. These make way more sense than basically paying someone to watch your money.

Editor's Note: Dividend payers crush other stocks. It's not a matter of opinion. You can just look at the stats. But what's really interesting is why they do so much better. We've found the answer here.

Disclosure:  Adam Fischbaum own QCOM shares in client portfolios

Adam Fischbaum does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.