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Financial Industry Insights from Advisors Asset Management

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The “I’s” Have It Series – Interest Rates

The direction predicted for many years appears to be lifting off, though the trajectory and whether escape velocity can be achieved are two important questions. Rates need to be reviewed on a Federal Reserve and broad-based central bank perspective as well as the market rates from debt to credit issued to consumers and businesses. Prior to the last FOMC (Federal Open Market Committee) meeting when the Fed raised rates, we noticed a pretty healthy jump in median expectations as they are signaling an increased propensity to raise rates, though at a very tepid and methodical pace.

The median expectations now have surged; however, the following chart from Deutsche Bank details the pretty heavy and erroneous bias to the path of rates over the last four years. Eventually, however, they will begin to be more accurate than what the recent track record has shown.


Many have said a hike in interest rates would have a large negative to households. However, the deleveraging that has occurred is significant as the multiple ratios show since the peak in 2008.


The amount of deleveraging with regard to household debt is historic. Consider the levels from the tops, from a nominal level: household debt would have to rise from $3.8 trillion from current levels to achieve the bubble target of 2008.

Disposable income would have to drop $2.7 trillion from current levels to achieve the same all-time high set in 2008. The disposable income figure looks to be on a significant path upward between potential tax cuts and tight labor markets combined with general economic pickup. Conversely, household debt could increase by $3.6 trillion if disposable income doesn’t increase from current levels. Either way, any increase of household debt to this magnitude would be a contributing factor of over 19% to GDP. As ludicrous as this may sound, any uptick in rates where savers earn more interest, consumption may increase substantially without very little impact on the debt picture for households. A methodical move in interest rates may counterintuitively be more stimulating to the economy than a burden. An increase in market rates could allow financial institutions to have more spread margin in lending and release a significant wave of economic activity.


The massive amount of refinancing has had a large impact on the corporate financing gap. For 72% of the time, the gap is positive, meaning companies are needing access to capital markets or credit. The displacement of interest rates by central banks has caused a refinancing of higher debt and made positive cash flow more common; this will only increase with lower tax rates.

As we discuss on the effective tax paid, so too is it on the corporate balance sheet when it comes to effective interest cost. This data is somewhat crude in nature, but we think it reveals an interesting relative comparison. Interest cost percentages are up but are in line with 1980, but below 1990 and 2000. These are based on the Barclays corporate aggregate index and total corporate profits reported on flow of funds from Fed.

Source: Barclays corporate aggregate index

As a byproduct of nearly eight years of historically low interest rates, companies have been able to refinance debt at a historical rate. The combination of lower interest rates and immense demand for any yield, future issuance is impacted. Consider the estimates from JP Morgan on various product estimated net issuance. (Billions)

 

2016 Est

2017 Est

% difference

Investment Grade Corp

$641

$511

-20.3%

High Yield Corporates

$125

$150

20.0%

Municipals

$2

$-89

N/A

Total

$1,550

$1,125

-27.4%

Total minus Treasury

$1,143

$706

-38.2%

Source: AAM

Looking forward with the proposed policies of the new administration, many are saying a continued decline in issuance may occur. This could occur depending on interest deductibility and potential desire to reduce leverage, net corporate supply may suffer. This could also occur on taking out higher paying debt with potential repatriation of dollars held in foreign banks. Municipals have the potential to see a reduction in refinancing and estimates range from a potential difference of +/- 50 billion. We have also noticed in the past that when there is a high degree of uncertainty in fiscal or monetary policy, issuance is often stalled.

CRN: 2017-0109-5727R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.