Below Zero

10 effects of negative real interest rates on equities

1. The valuation of equities
How do you value a stream of cash flows when the risk free rate is zero? The longer yields are close to zero (negative in real terms), the greater the chances of further multiple expansion.

2. The relative return of equities vs. bonds
A low bond risk premium and high equity risk premium should result in out-sized relative returns for equities for some time; even though there is a danger that absolute returns are low.

3. The uses of cash
Companies have record amounts of cash and more aggressive uses of cash – particularly M&A – are now being rewarded.

4. Financial leverage
Financially levered stocks have performed well; this should continue given the low level of rates and spreads. Managements are increasingly issuing longer-dated debt to ‘bake in’ low rates; accretive for earnings.

5. The attraction of dividends
In a world of zero rates, demand for income becomes ever more difficult to satisfy. Dividends are increasingly attractive, especially if they can grow.

6. The price distortion of ‘bond proxy’ stocks
These sectors no longer offer much yield – like the bond market! Since the announcement of QE they have underperformed – expect this to continue.

7. The impact on duration
Lower yields have led investors to longer-duration names, more cyclical growth has been less popular, but this should shift.

8. The impact on Banks
Low rates and a flat yield curve are negative for NII; volume growth will not be sufficient to offset this. But there are other ways for banks to perform – restructuring, M&A, lower NPLs, and growth in other risk-related business.

9. The impact on Insurance
Risks are high for those exposed to guaranteed products in the Euro area, with the impact worsening the longer rates stay low.

10. The impact on pension deficits
Stocks with large pension obligations are at a 20% discount to the market.

Goldman Sachs International – Portfolio Strategy Research