Low-Interest Rate Environment Has Not Boosted Business Investment

A low interest rate environment is meant to spur economic activity, but inflation remains anemic in most advanced economies and a prolonged period of low-interest rates has introduced potentially destabilizing financial distortions that’s the summary of a presentation from Moody’s Investors Service, which considers the low-interest rate environment and its impact on credit.

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Low-interest rates are supposed to make financing more accessible, stimulating business investment and economic growth. However, as Moody’s points out, investment remains stuck at record lows despite record low-interest rates. Investment as a percentage of GDP remains below pre-crisis levels in the UK, US, Japan, and Europe area.

Low-Interest Rate Environment

Moody’s concludes that the lack of investment despite low-interest rates implies that real interest rates may still be too high. Expected real rates of return may be very low in the context of deficient demand. But there’s a problem, financial stability may be jeopardized if rates break further below the effective lower bound of zero. If banks start charging negative rates on deposits because their margins are being squeezed, there is a point where depositors may turn to cash, which would defeat the object of the exercise. The only way to depress real rates further is to bring up inflation expectations through higher inflation targets, nominal GDP targeting or helicopter money.

Moody’s How Is The Low-Interest Rate Environment Impacting Credit?

Moody’s goes on to warn that the current prolonged period of low-interest rates has introduced a host of unintended consequences. Cheap borrowing is further bolstering asset prices, making a potential correction all the more painful. Meanwhile the search for yield is leading investors to shift capital in (and out) of emerging markets, creating instability in foreign currency markets and banks are struggling to stay afloat with negative deposit rates; if sustained, this could lead banks to curtail lending, make riskier investments to boost revenues or pass on costs to customers, triggering a wave of potentially destabilizing deposit withdrawals. Furthermore, low-interest rates may reinforce low growth by keeping inefficient firms in operation.

Another problem to consider is how interconnected the global financial markets have become. The potential normalization of US monetary policy brings risk to emerging markets, particularly Turkey and South Africa which are reliant on external financing.

So what does this all mean for credit? Well, Moody’s concludes that low-interest rates and the disappearance of the term premium, a result of low growth/inflation environment, negatively impacts credit across sectors. Low growth has a negative impact on revenues and margins, while low inflation makes de-leveraging more difficult. On the other hand, borrowers who did not lever up excessively stand to benefit from lower rates.

Overall, some companies are set to benefit more than others and some sectors will also be more affected than others. Moody’s concludes that while sector positioning is important, issuer response is key.

Companies that take actions to reduce borrowing costs, lengthen maturities and protect profitability are in the best position to take advantage of the current environment while those that decide to increase leverage, especially to finance riskier investments (increase in M&A activity, interest-only mortgages, convenant-lite, share buybacks and dividend payouts at the expense of productive investment) are the most at risk of succumbing to low interest rate risks.