2nd Quarter 2016 Commentary

Negative Interest Rates Or We’ll Pay You to Borrow from Us!

Imagine being a home owner in Aalborg, Denmark and receiving an interest check from your mortgage holder paying to you, the mortgagee, for borrowing money to buy the house in which you live. We think you would be forgiven for a shocked reaction thinking you had “died and gone to heaven.” Or for wondering which “party drug” your banker might be using.  This is a true tale. This did happen. Welcome to the new world of negative interest rates.

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On a much larger scale, the European Central Bank (ECB) is about to embark on a new targeted lending program to commercial banks throughout the Eurozone called TLTRO II. The objective of this scheme is to encourage banks to lend to companies and households. The banks will initially be charged zero (0%) for their borrowings from the ECB. If a bank enlarges its eligible loan book by 2.5% by the end of January 2018, the cost of the bank borrowings could fall to the deposit rate, now -0.4%. In other words, the European Central Bank will pay commercial banks to borrow money under TLTRO II (Targeted Long Term Refinancing Operation) in an attempt to spur business and ultimately to increase inflation. In fact, the ECB is not the only authority to experiment with negative interest rates – so also are the Swiss and the Japanese central banks. It is still “early days” with this experiment. One of the results for which the Swiss and the Japanese had hoped was a “cheaper” exchange rate. Unfortunately, in both cases, the exchange rate has appreciated rather than depreciated. Nevertheless, central bankers in all three economies (especially the Japanese and the Eurozone) are hoping that the primary objective of more business being conducted will be achieved. The “jury is still out” on that score. It would certainly seem to make sense that eligible borrowers would “be frothing at the mouth” at the prospect of cheap money or even better, being paid to borrow money to invest in a venture. Certainly there is a lot of liquidity in the marketplace. People simply have to be persuaded to “take the plunge”. In the US, there has been academic discussion about negative interest rates. Money in America is cheap – but no US bank to date is paying interest to borrowers. Chair Yellen has said that negative interest rates are certainly in the Fed’s “toolkit”. But at the moment, the Federal Reserve Governors are not yet ready to “pull that trigger”.

We are now going back to a chart we have used in the past which looks at the correlation between weekly stock returns and interest rate movements.


A low interest rate environment is usually good for equity performance, as bonds offer little competition for investment flows. Further, even as rates rise from a low base and not until interest rates rise to approximately 5%, equities have historically done well.

Further on some comments we made in our last quarterly commentary regarding tough transitions, the following charts examine employment and income by educational attainment.


Graphically, the reader will understand the frustration felt by those who perceive themselves as “left behind”. Those with less than a college degree suffer the highest unemployment and earn the least by a large margin. With these circumstances, it is not hard to appreciate the discontent. In an election year, this disquiet has manifested itself in millions being mesmerized by certain candidates’ populist rhetoric and vague slogans which promise much, but which are founded on ideological “drivel” with little intellectual substance. The sirens are singing – and their songs are being heard. So far the US and other markets have not paid much heed to the possibility that one of these sirens could become the next President of the United States. We would agree with the markets so far. But we will keep a close eye on the race because we think that should a “populist sounding” candidate win the grand prize, markets around the world would not react well.

As an example of not “reacting well”, the United Kingdom (UK) just voted to leave the European Union (EU) – to Brexit. Around the world markets have declined, except those considered “safe havens” like the US dollar, US Treasuries, the Japanese Yen, gold and the Swiss franc. In a rare show of unanimity, reputable economic experts of just about any “stripe or color” agreed that the economic impact of Brexit was virtually all negative. According to the London School of Economics and Oxford, “…the risks here are asymmetric to the downside”. So the decision to leave seems irrational. Nevertheless, it is what it is. But what does it mean for investors? First, Great Britain is just 4% of global GDP – so not big enough to derail the world economy. A recession in Britain is bad for England, but the world shouldn’t “get pneumonia”. Also the UK will probably not be leaving the EU for years and until then will operate as it has within the EU.New trade treaties must be negotiated, “red tape” must be removed and new relationships put in place. Markets, however, have reacted as if everything will be decided and enacted by next Monday – no chance. Conspiracy theorists have already started to “spin webs” about the next four countries to leave the EU and the EMU. We may get there, but we are not there yet. Already in anticipation of such musings, the leaders of the Eurozone are circling their wagons in defense of the Eurozone. No one should expect the EU to give up easily. In fact, there is postulation that the upcoming divorce negotiations with the Brits will be especially difficult in order to dissuade others from pursuing a similar path. There is uncertainty in the world. Markets hate uncertainty and always trade down on perceived elevated risk. But the risk associated with only the UK leaving the EU is not massive and we believe that given a bit of time to settle, risk assets like equities will move ahead again, supported by higher earnings.

Let’s end this commentary with a look at an important segment of industrial America – the chemical business, a pretty fundamental force in our economy and an important indicator of its health. The Chemical Activity Barometer has been published monthly since 1919 by the American Chemistry Council and is up 2.5% in the past year. This barometer suggests that industrial production will pick up in the near future. Over a long time, as can be seen by the chart below, this index has correlated with overall economic activity quite accurately – which should hearten those who are concerned about the state of the US economy.


Further, the next chart demonstrates nicely that the Chemical Activity Barometer leads growth in industrial production and by inference, the overall economy.



1) U.S. economic growth will continue at a pace of around 2.5% – 3% Yes – Growth picked up in Q2 to 2.5%

2) U.S. inflation will remain quiescent Yes

3) The dollar will stabilize, perhaps strengthen a bit more Yes – Brexit has given a boost to the Greenback

4) During 2016, oil’s price will find a bottom not far away from now and will rally into 2017 Yes – Analysts are now raising price projections for 2016

5) Interest rates will rise – but the rate of increase will be slow No – Due to Brexit uncertainty, “safe haven” US
bonds have rallied & interest rates are down

6) Political reform will grow in South America Yes – Rousseff impeached

7) It will be another “Banner Year” for mergers and acquisitions Yes

8) Consumer spending will improve Yes/No -On cars & houses, yes; on clothing, no

9) Émigrés will continue to be a “hot potato” politically around the world Yes

10) Amongst the popular investment alternatives, equities should do the best No – Not yet, but still believe


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The opinions expressed in this Commentary are those of Baldwin Investment Management, LLC.  These views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed.

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