As One River’s Chief Investment Officer, Eric Peters, put it over the weekend, “today’s most important question is whether the inexorable trend toward zero is good or bad for stocks.”
He then lays out his answer in the form of one of his inimmitable whimsical, “fictional” responses – which not accidentally hints at Tesla – as presented below.
Anecdote
“Today’s most important question is whether the inexorable trend toward zero is good or bad for stocks,” explained Lithium, hands free on Highway One.
“The more we have considered this simple question, the better we’ve become at articulating a simple answer.” Low rates are quite obviously supportive for stocks, at least in America. Where the S&P 500 now trades at all-time highs, with bond yields at historic lows.
“While declining interest rates are good, really low rates are bad,” he said. “When long-term rates decline you can assume growth is declining.”
The lower cost of capital supports higher equity multiples, which is good initially. But high multiples reward entrepreneurs for building new businesses, and in a low-growth economy they cannot grow quickly by profiting from a rapidly expanding pie.
“New businesses are built to target fat margins earned by incumbents. They come in and disrupt everything.” Any time there are big profits, you find fat around them, inefficiencies, empires.
New capital doesn’t need those things. And it doesn’t require fat margins, it simply needs high revenues. So when rates get low enough, all the corporate moats that had protected profits get breached. Which makes older companies less attractive, even when they offer higher yields.
“In a robust growth environment your moat can remain intact because newcomers tend to target the growing pie. But without expanding pies, all they can go after is existing slices.”
As rates and growth converge at low levels, legacy investments modelled on more optimistic assumptions struggle. Many fail. The pressure on incumbent profit margins from these newcomers simply exacerbates their troubles. “So that feedback process of interest rates below a certain level becomes quite destructive to the existing base of capital,” explained Lithium. “That’s the simplest answer.”
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