Throughout the 1970s into the 1990s, central bankers fought to stifle inflation. As the 1990s went on, they felt they had won; in the 2000s they were wary. Through the 2010s they have had new problems — not enough inflation, not enough demand, not enough investment. In an effort to stimulate investment, they have now pushed interest rates down to near-zero levels. Yet businesses have mostly responded by continuing not to invest.
So now central bankers such as Reserve Bank of Australia governor Philip Lowe are concerned that companies have failed to adjust to a world of near-zero interest rates. In particular, Lowe and others worry companies have not cut the minimum rate of return that they require in order to invest — the so-called “hurdle rate of return”.
An incredible world
As Lowe pointed out in an October speech, economists of earlier eras would not have believed today’s world possible. They thought zero interest rates unattainable. Yet we now
see zero or lower rates in Germany, France, Japan and elsewhere. Governments are borrowing for literally nothing, or even less than nothing.
“Around a quarter of all government bonds globally are now trading at negative yields,” noted Lowe. But as he pointed out, commercial rates are at least as strange. Coca-Cola, Orange and Siemens have all now issued unsecured bonds with negative yields. In Denmark, Lowe reports that at least one bank has issued a residential mortgage at a negative rate of interest — 0.5 per cent.
Lowe quoted one of the Reserve Bank’s creators, Sir Leslie Melville, imagining an investment frenzy as rates went to zero. Roads would be straightened, mountains dug away, deserts watered and artificial seashores created, mused Melville.
His rationale made sense: at near-zero rates, all sorts of previously unimagined investments should become more attractive.
A 2017 Harvard Business Review article — Strategy in the Age of Superabundant Capital — described financial capital as “no longer a scarce resource”. Instead, it said, capital had become abundant and cheap. Like central bankers, executives needed to throw out the technique taught to them since the 1980s — in their case, finding the “sure bets” that clear high hurdles. “Companies must lower hurdle rates and relax the other constraints that reflect a bygone era of scarce capital,” it recommended.
When capital is expensive and scarce, the HBR authors calculated, improving profitability brings greater reward for effort. But when capital is abundant and cheap, increasing revenue growth matters more.
So their advice was to focus on growth by making many small bets that explore opportunities. Companies already doing this, they suggested, included Google parent Alphabet, and food groups Kellogg’s, General Mills and Campbell’s.
A world short of investment
But if this was the winning strategy for the near-zero age, not enough companies have recognised it. Today’s near-zero world is not one of frantic investment spending. Indeed, Australia represents almost the opposite: business investment has dropped to levels not seen since the mid-1990s.
One possible reason for this is, as the RBA’s Lowe put it, global hurdle rates in many countries remain around 13 to 14 per cent. Near zero interest rates have not changed that.
Lowe offered two explanations:
- Firstly, that uncertainties over technological and regulatory change, globalisation and economic policies such as the developing US-China “trade war” — albeit now cooling — have combined to make investors demand a higher risk premium. So hurdle rates have stayed high even as official interest rates have fallen.
- The second possible explanation is that, in economics-speak, the hurdle rate has proved “sticky”. It takes time for people to get used to the idea that today’s hurdle rate may be well below the traditional 13–14 per cent.
Lowe argued that both explanations are partly true.
Take the money!
One of Lowe’s RBA board colleagues, Melbourne Business School dean Professor Ian Harper FAICD, has a stronger view. While stressing he is not speaking in his RBA board capacity, Harper says in today’s remarkable circumstances, many companies need to look again at their hurdle rates.
“Even if you think this is all just an aberration, that it is going to go away in a few years — well, why wouldn’t you borrow for 30 years now, and pay five per cent, 400 basis points above what the Commonwealth has to pay?” he asks. “That’s still going to be below, I would conjecture, anybody’s hurdle rate.”
“The market is telling you, take the money, for God’s sake, take the money!” he argues. “This is the situation where investments you would normally reject because all the payoffs are loaded way out — it’s 10, 15, 20 years before you get any payoffs — this is just the sort of time when those sorts of projects ought to be pulled out of the bottom drawer and funded now. Now is their time.”
IBISWorld chair Phil Ruthven AM FAICD is also arguing for dropping hurdle rates, “certainly for three-year, if not also five-year, financial plans”. After all, he points out, share markets have raised price-earning ratios as bond rates have fallen.
There are arguments for being more careful with hurdle rates. Robin Low GAICD sits on boards including Appen, AUB Group and IPH. She also has reservations about hurdle rates, in particular for listed companies, and says the rate of return shareholders expect to see on their equity has barely changed. The task of meeting those expectations looms much larger in corporate decisions than calculations based on the cost of borrowing.
“In a listed company environment, you’ve got an expectation built into your share price as to how much you’re going to grow as a company,” says Low. “You can see what multiple people put on your price.” Whether you “delight or disappoint”, she notes, depends on whether your growth outstrips or lags behind that multiple.
Lendlease chairman Michael Ullmer AO FAICD reportedly shares those views, telling the Australian Financial Review that Lendlease’s weighted average cost of capital had not changed hugely and that shareholders expectations had not been lowered.
Peter Swan AO, professor of finance at the University of New South Wales, agrees the cost of equity in Australia “hasn’t shown many signs of falling”. And that, he says, outweighs any effect from a change in hurdle rates.
The other way around
Swan also suggests that despite Lowe’s puzzlement, the hurdle rate today lacks the significance it once possessed. “The thing to understand is that the world has changed a lot,” he says. “Thirty years ago, 80 per cent of assets took a tangible form, and they were largely in manufacturing. Today, it’s probably the other way around: 20 per cent of assets are tangible, and the other 80 per cent are intangible. That’s the pricing of Google and Microsoft and all of these high-tech companies, and the value of patents and trademarks, things of that sort.”
Australia, he notes, has been mostly unsuccessful at promoting such companies — businesses that often win copious funding with little or no profit. For those businesses, hurdle rates matter less than the size of the opportunity and the brainpower they can devote to it.