COVID-19 is the gravest health threat to emerge around the globe in the last hundred years.
Not only is this virus a health crisis, but it has also morphed into an acute financial crisis as entire industries are impacted and economies are hit badly.
The difference now is that countries are equipped with central banks, which can act to prop a country’s economy up using both monetary and fiscal stimuli.
During this crisis, numerous countries have taken the drastic step of cutting interest rates to boost economic growth.
Colombia’s central rate has cut rates seven times in a row to a record low of 1.75%, while Mexico has recently cut its rates for the eleventh consecutive time to 4.25%.
In the US, the Federal Reserve has slashed rates to rock-bottom levels and maintains that they will stay “lower for longer” until inflation hits 2% and a wider economic recovery is seen.
And in the UK, the Bank of England is preparing to cut rates to below zero in 2021 as the pandemic ravages the country’s economy.
As it stands, low rates are fast becoming the norm but are they good for stocks?
Capital needs a place to go
The immediate implication of lower interest rates is that savers lose out as they park their money in bank deposits or money market funds.
Local banks have been lowering their deposit rates in response to lower rates around the world.
This trend has pushed investors to seek avenues for higher returns, thus encouraging risk-seeking behaviour.
A good indication may be the recent craze over technology IPOs.
With the bulk of old-economy stocks performing poorly, the excess capital from disgruntled savers will naturally flow to companies that offer brighter growth prospects.
What investors face is an increasingly bifurcated market – the cheap stocks remain cheap or see their valuations plunge even lower, while the red-hot, popular stocks get pushed to sky-high valuations.
In a nutshell, you should be wary if you think of investing in stocks that promise a higher return, as it may imply that they are hyped up.
Binging on cheap debt
It’s not only investors’ attitude that changes with such low rates, but companies are also guilty of partaking in riskier behaviour.
Companies may view low interest rates as a perfect opportunity to load up on more debt to fund their growth plans.
That is the expectation.
After all, the aim of keeping rates low is to stimulate borrowing, creating a virtuous cycle where businesses borrow cheaply to invest in productive assets and ventures.
However, taken to the extreme, some companies may start binging on cheap debt and end up overextending themselves.
Risks still abound as the COVID-19 pandemic is far from over, and no one knows what the new normal may look like.
The good and the bad
Low interest rates do benefit REITs, though, as such property-owning vehicles rely on a steady stream of debt to fund their operations.
Several REITs have embarked on acquisitions in recent weeks as borrowing costs remain low and asset prices become more attractive.
On the flip side, bank stocks generally do not perform well in a low interest rate environment.
Banks make money by taking in deposits from customers and then lending this money out to businesses, earning the difference in rates (known as the “spread”).
Lower rates mean that banks earn less interest from loans, while rock-bottom deposit rates mean that their spread keeps getting compressed further, putting a damper on banks’ earnings.
Negative implications
If rates remain low for a prolonged period, it signals that the economy is faring poorly.
By extension, this also implies that inflation is low as weak demand for goods and services results in businesses being unable to charge more.
Low rates are generally symptomatic of a weak economy with high unemployment rates and poor business prospects.
In such a scenario, stocks are not expected to perform well as their underlying businesses will struggle.
Although companies may be able to borrow cheaply, it does not always mean that they have avenues to grow their top and bottom lines as the overall outlook may remain muted.
Get Smart: A double-edged sword
There’s no easy answer as to whether low rates are good or bad for stocks.
For some sectors, low rates could be a boon; but for others, it may signal more trouble ahead.
Investors should also be wary of unintended consequences, where companies over-borrow and get themselves in trouble.
Low rates are a double-edged sword that you need to assess warily before making any investment decisions.
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Disclaimer: Royston Yang does not own shares in any of the companies mentioned.
