On the Risks, Costs and Benefits of Ultra-Low Interest Rates and the Blue Zones of Longevity – Final Part!

From: aditya rana
Date: Sun, Nov 17, 2013 at 2:26 PM
Subject: On the Risks, Costs and Benefits of Ultra-Low Interest Rates and the Blue Zones of Longevity – Final Part!

Hi!,

The financial crisis of 2008 prompted central banks in the developed world to pursue unconventional monetary policies to (initially) prevent economic collapse, and subsequently, to support economic growth. There exists considerable disagreement on the risks and benefits of these strategies and a recent report from the McKinsey Global Institute sheds some light on this important issue

( http://www.mckinsey.com/ ). As an investor (or for that matter any individual with an exposure to the world economy) it is critical to understand the implications of an eventual reversal of the Fed’s monetary policy – as Warren Buffet said recently (in his inimitable way) – when the Fed ultimately starts to raise rates, "it’s likely to be the shot heard around the world". To summarise:

-There is widespread consensus that the unconventional policies (ultra-low interest rates and asset purchases) implemented by the major central banks in the developed world in the aftermath of the financial crisis of 2008 were necessary to prevent a deeper recession. Multiple studies show that these policies increased GDP by 1 to 3%, reduced unemployment by 1% and prevented deflation, and these estimates would be much larger if the global economy had headed into a depression.

-However, five years later, central banks continue to use these policies to keep interest rates near zero, to inject liquidity into markets through asset purchases (see chart below) and provide credit facilities to banks, leading to negative real rates.

-The note analyses the income and wealth effects of these policies on governments, corporations, banks, institutional investors and households (see chart below) and on cross-border flows to emerging markets. It concludes with an analysis of the risks associated with a reversal of these policies.

-Between 2007 and 2012, governments in the U.S., U.K. and the Eurozone have collectively benefited by $1.6 trillion due to ultra-low interest rates through reduced debt service costs and profits remitted by central banks (see chart below).

-However, households in these countries have lost $630 billion in interest income, with the younger households (being net borrowers) gaining and the older households (having interest-bearing assets) losing income.

-Non-financial corporations benefited by $710 billion through lower debt service costs, but this has not translated into increased investment, perhaps because the recession reduced expectations of future demand.

-The period of ultra-low interest rates resulted in a cumulative net interest income loss (as margins declined) of $230 billion for European banks, while U.S. banks gained $160 billion of net interest income as their financing costs declined by more than what they received on their assets.

-Institutional investors like insurance companies, particularly in several European countries, face a bleak future if these policies continue as interest rates are below the guaranteed yields being paid to customers.

-The ultra-low interest rates have had a significantly positive impact on bond markets, with the value of sovereign and corporate bond markets in the U.S., U.K. and the Eurozone rising by $16 trillion between 2007 and 2012 (see chart below).

-There is little evidence that the ultra-low rate monetary policies boosted equity prices beyond the short-term impact of policy announcements – and a large-scale shift into equities as part of a search for yield is not discernible. P/E and P/B ratios in stock markets are not higher than long term averages (see chart below).

-Ultra-low interest rates have had a positive impact on the housing market, with house prices in the U.S. and the U.K. being about 16% higher due the lower cost of borrowing. However, in the U.S. the traditional relationship between interest rates and housing prices is muted due to structural factors like an oversupply of housing and tightened credit standards.

-While the increase in household wealth (and consumption) arising from higher housing and bond prices as a result of ultra-low rates far outweighs the loss in household income (see chart below), it is not clear that the additional consumption from rising wealth offsets the tangible loss to household cash-flows and spending arising from the decline in interest income. This is because asset prices still remain below their peak in most markets, and it is more difficult for households to borrow against the increase in wealth.

-While FDI flows continue to have the highest percentage of capital flows to EM countries (64% – averaging $723 BN per year between 2009 and 2012), ultra-low interest rates appear to have led to higher portfolio flows into emerging markets, particularly into their bond markets (see chart below). EM bond purchases by foreign investors rose from $92 BN in 2007 to $264 BN in 2012, driven by higher yields and better macroeconomic and credit conditions in EM countries than those prevailing in the developed world. EM countries which have a large percentage foreign ownership of their bond markets (Eastern Europe, Turkey, Poland, Brazil, Mexico and Indonesia) and large current account-deficits, will be most vulnerable to capital outflows when rates begin to rise in the developed world (from June 2013, 19% of previous bond inflows from 2009 were pulled out of EM countries – see chart below).

-In conclusion, the key risks likely to arise from a reversal of unconventional policies by the central banks in the developed world are:

1) increased market volatility as these policies have lowered volatility in key markets (see chart below),

2) an increase in government debt service costs of upto 20%,

3) an increase in household debt service costs ranging from 7 to 20%,

4) lower profits (25% of the growth in profits in the U.S. since 2007 has been a result of lower rates) and an increase in capital costs (as real rates increase) for non-financial corporations,

5) reversal, and increased volatility, of capital inflows into emerging market – particularly countries with a high percentage of foreign ownership of their bond markets and with high current account deficits (see chart below),

6) significant losses for banks, life insurers and other investors in bond markets as rates increase, and,

7) collapse of the leveraged carry trades in a variety of markets, including currencies, bonds, real estate and private-equity.

An important note which brings forward a focus on the potential impact of eventually rising interest rates in the developed world on asset market across the world – perhaps the single most important risk we face in the coming few years. While the current expectations of rising U.S. rates is 2016, it is highly dependent on economic growth and unemployment rates we experience over the course of 2014. If 2014 growth surprises on the upside ( i.e. 2-3%) and the unemployment rate trends down towards the likely new threshold of 5.5% (and inflation begins to tick up), then we can expect the timing of rate increases to be pushed forward to 2015 which implies a turbulent second-half of 2014 as the market begins to anticipate a reversal of Fed policy. We witnessed a brief preview of this scenario during the summer and it does not bode well for most risk assets, in particular the leveraged carry trade (i.e. real estate, high yield bonds, EM bonds and currencies, dividend stocks, REITS etc). However, at this stage it’s advisable to be "cautious but not bearish" given that the Fed is unlikely to taper from December (base-case being March 2014) and the high likelihood of a second round of an LTRO type operation by the ECB before year-end.

The Blue Zones of Longevity- Final Part:

This is the seventh part of the summary of the recent book: "Blue Zones: Lessons for Living Longer From the People Who’ve Lived the Longest" written by Dan Buettner, an internationally recognized explorer and educator. The Blue Zones are five specific towns or regions around the world, where people are up to three times more likely to live to be at least 100 years old, while remaining active, with a significantly lower rate of disease. The Blue Zones include the Barbagia region of Sardinia in Italy, Okinawa in Japan, the community of Loma Linda in California, the Nicoya Peninsula in Costa Rica, and the Greek island of Ikaria.

Lesson 4: Drink red wine in moderation.

-Studies have shown that a daily drink of wine or spirits can have health benefits – but a study of the Blue Zones shows that consistency and moderation are key. While red wine has artery scrubbing polyphenols, and alcohol can reduce stress , it has also been associated with a higher risk of breast cancer and has toxic effects on the liver, brain and other organs when daily consumption exceeds a glass or two.

-Lesson 5: Have a goal in life.

-Studies have shown that individuals who have a clear goal in life – something to get up for in the morning – lived longer and were more alert than those who did not. Purpose can come from a job or a hobby – particularly if you immerse yourself completely in it. This could include learning a new musical instrument or a new language.

Lesson 6: Take time to relieve stress.

-People who live until 100 possess a sense of sublime serenity – they are wise enough to realise that many of life’s best moments can pass you by if you are too busy. In the words of a 107-year old Sardinian lady " Life is short. Don’t run so fast that you miss it". Activities like yoga and daily meditation can help us slow down.

-Less stress may also lower inflammation which tends to increase as we age causing a host of age-related chronic diseases like heart disease, Alzheimer’s and diabetes.

Lesson 7: Participate in a spiritual community.

-Healthy centenarians everywhere have faith and belong to religious communities. Various studies have shown that those who attend religious services regularly (at least once a month) are 20 to 30% less to die at any age. Belonging to a religious community can foster large and closer-knit social networks.

Lesson 8: Make family a priority.

-The most healthy centenarians in the Blue Zone out their families first and built their lives around their core families. Their lives were imbued with familial duty, ritual and an emphasis on togetherness. Families represent the highest degree of social network.

-Studies have shown that elders who live with their children have less incidence of diseases, eat healthier diets and have lower stress. Successful families make a point of spending time together – eating at least one meal a day together, taking annual vacations and spending family time.

Lesson 9: Surround yourself with people who share Blue Zone values.

-This is perhaps the most important aspect to make your life healthier. Residents of longevity cultures work and socialize together, thereby reinforcing their adherence to good practices and habits.

-Social connectedness is ingrained amongst the resident of the Blue Zones – studies have shown that people with the most social connectedness lived longer. All the centenarians interviewed were cheerful and likeable – and therefore had stronger social networks, had less stress and lived purposeful lives.

The calculus of ageing offers us two options: living a shorter life with more years of disability or living the longest possible life with the fewest bad years – the choice is upto us.

Here’s to incorporating as many of the Blue Zone habits into our daily lives!

Regards

Aditya

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