Saturday, March 20, 2021

"Interest rates and the rise of Neofeudalism"

From the Yield Blog:

Historian Paul Schmelzing recently published an exceptional working paper on eight centuries of global real and nominal interest rates, from 1311 to 2018.

 What he discovered surprised me: nominal and real rates over very long periods of time are in "suprasecular decline" and that the fall in real and nominal interest rates over the last forty years are merely a reversion to long-term historical trends. When I say "interest rates", I mean both literal rates (paid for debt servicing), as well as effective rates (i.e., at what earnings multiple stocks trade). Schmelzing is more limited in his definition but I will use the term "falling rates" to mean both lowering bond yields and rising equity multiples.

What's more surprising, the rate of decline is fairly "rapid" across human history at about 2 basis points (.02%) a year. In 100 years, interest rates will be a full 2% lower in expectation. If this phenomenon is reliable and persists into the future, what will the world look like when interest rates are near-zero or negative? Allow me to engage in some rank speculation.

1). Outsized wealth creation will no longer be possible by professional "asset compounders" like Warren Buffett because there's not a lot of "compounding" one can do when rates are so low. I mean this very literally: since expected human lifespans are only getting a little bit longer, and the Rule of 72 remains true for all non-relativistic finance we literally can't live long enough to compound enough money to move the needle.

Instead, capitalism will heavily favor "asset gatherers" and "money-raisers" that invest in direct capital projects -- people who raise a lot of money to do something low-return and (legally) skim a bit off the top, because there's going to be simply so much more money floating around and the return hurdle is so much lower. Insofar as this is already painfully true of capitalism by the early 2000s and 2010s, it will be even more the dominant reality for our grandchildren's grandchildren. Someone like Warren Buffett was truly born in the right decade: a time when, at the midpoint of his life, interest rates were unusually high (i.e., assets were unusually cheap) and began a long decline, driving outsized returns for "professional capitalists" and especially for value investors who correctly assigned a very high cost of capital to earnings. The dominant model of wealth creation has shifted from squirrely hoarders like Buffett to either bombastic asset gatherers like Adam Neumann, or to extremely talented builders like Elon Musk, in part because interest rates are much, much lower.

2). Monopolies will be more valuable than ever and non-monopolies will trade at more significant discounts. As required returns lower, capital will flow toward non-monopolistic, competitive industries (think Quip, Boll & Branch, and whatever other favorite podcast sponsor you have) and reduce returns in those industries even further than where they are now. What really matters isn't how much money a company is making per se, but the certainty that they will earn those returns in the future. This certainty in maintaining pricing, margins, and market share enables investors to capitalize businesses at very high multiples because there's "nothing else left to invest in". More on this later.....