Low Interest Rates Might Not Be Good for Banks, But They’re Not Good for Anyone

Interest Rate Crash
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All-time highs in the US again overnight!

Only this time, the major exchanges acted in unison. The Dow, the S&P 500 and the NASDAQ hit all-time highs together for the first time since 1999.

Nothing major happened to send the exchanges higher. Decent earnings figures from retailers and good — but not too good — economic data gave the market confidence that the economic expansion will continue without a Federal Reserve rate rise.

And that’s pretty much all you need to know, folks. As long as the news is OK, but not strong enough to bring about a rate rise, the market will continue grinding higher.

Don’t be fooled by the fact that this is the first time since 1999 that the exchanges hit all-time highs together — 1999 being a pretty seminal year and all.

It looks like the retail investing public is still cautious about US equities. According to an article in ValueWalk, combined flows from ETFs and mutual funds (equivalent to managed funds in Australia) indicate that retail money is still flowing out of US equities.

Morgan’s figures show that including flows from mutual funds, equity funds have seen outflows of $68.2 billion so far this year, that’s including the $31.8 billion of inflows into equity ETFs. Meanwhile, fixed income funds (both mutual funds and ETFs) have seen inflows of $163.4 billion.

Money flowing out of equities as stocks hit all-time highs indicates a low probability of a major crash anytime soon. That doesn’t mean you won’t see sharp corrections from time to time, but a prolonged bear market doesn’t tend to get underway when retail investors remain hesitant.

On the other hand, retail money is piling into fixed income funds. This shows you how desperate investors are for income. While these stats on the fixed income market indicate that bonds of all kinds are in bubble territory, don’t forget that central banks are a major backstop in this market.

The Bank of England just raised the prospect of buying corporate bonds in its latest announcement. Central banks will keep buying until they own the fixed income market. And they’ll trash their currencies in the process.

This is why I’m a long term bull on gold. The rally is taking a breather right now, though, and will probably continue to consolidate for the next few months. But it’s just building the energy for another move higher. Here’s how you can take advantage of it now.

How the Australian Stock Market Reacted To Low Interest Rates

What about the Aussie market? Earnings season is underway, and the market’s response has so far been a little underwhelming. Having said that, it did rally strongly leading into the results, so what you’re seeing now is a little profit-taking after that strong run.

Let’s have a look at the chart of the ASX 200. After a strong rally since the end of June (on the back of hopes of a rate cut), the RBA promptly delivered one in early August…only for the market to sell off. There’s just no pleasing some people…


Source: BigCharts
[Click to enlarge]

The selloff resumed this week with the release of full-year results from the Commonwealth Bank [ASX:CBA]. Much was made about the bank’s record cash profit of $9.45 billion, which was up 3% on last year.

But the stock market rewards profitability over profits and, on this front, the CBA went backwards. The best measure of profitability, return on equity (ROE), dropped 170 basis points over the past 12 months, from 18.2% to 16.5%.

This is still a strong number, but it’s going in the wrong direction. In essence, the CBA is still able to generate record profits, but it’s taking more equity capital to do so. Hence the declining ROE.

Of more concern to the market was the visible slowdown in the second half of the year. Operating incomes (similar to revenues) across the banking, funds management and insurance business were down 1% over the six months to 30 June. A 23% rise in impairment expenses saw second half profits fall 3%.

In another concerning sign, the bank’s powerhouse division of retail banking services (or should I say former powerhouse division) recorded flat net profit after tax in the second half. That’s the first time I can remember in quite a while that this division (which includes the bank’s bread and butter of mortgage servicing) did not contribute to profits.

Perhaps that is why CBA boss Ian Narev said that low interest rates are not great for banks. As the Financial Review reported this week:

“There are aspects of the performance that are very highly leveraged to the environment, and people keep forgetting low interest rate environments are not great for banks,” Mr Narev said. “All things being equal, a declining cash rate will mean a declining margin. We need to stare into the fact that absent any action on our part, that will occur.”

Narev’s comments need refining. He means very low interest rate environments are not good for banks. When rates are falling, but are still relatively decent, of course they are good for banks.

People borrow more and this helps banks expand their balance sheets. But beyond a certain point, monetary policy loses its ability to promote further debt growth. It goes from encouraging people to take on risk, to discouraging them through the highly worrying signal of very low, emergency, ‘OMG’ levels that rates are at now.

Those that rely on interest rates for income become more conservative. People see that the conditions that have caused the ultra-low rates in the first place are reason enough to keep their heads down.

Low interest rates might not be good for banks…they’re not good for anyone.

Regards,

Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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