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Morningstar’s investment philosophy rests on evaluating a company’s economic moat—its ability to sustain returns above its cost of capital for an extended period of time—and the price of its stock in relation to our estimate of fair value. As a result, macroeconomic forecasts are generally a secondary concern.
However, there are some cases in which macroeconomic variables can dramatically impact the cash flow a firm can produce. Indeed, most companies are price-takers to some extent, producing commodity products for sale at the prevailing market rate. Warren Buffett described these firms as “businesses”—contrasted with more attractive “franchises”—in his 1991 letter to Berkshire Hathaway shareholders:
"A "business" earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack."
To value these businesses, investors must have a view not only on a company’s cost position, but on the market prices likely to be realized for its products over an extended time frame. However, prices in some cases can be extremely volatile. Over the last decade, for instance, oil prices have doubled, fallen by half, then doubled and fallen by half again.
Banks are doubly exposed to market prices, as they are price-takers on both sides of the balance sheet. Maturity transformation—borrowing short-term and lending long-term—is one of the most important functions of a bank. Both borrowing and lending rates—and therefore net interest income—are largely dependent on the yield curve. As net interest revenue represented about half of total revenue produced by large U.S. banks in 2015, the long-term level of interest rates is an important factor in bank valuation.
Historically, the U.S. yield curve has been conducive to this maturity transformation. Inversions in the yield curve have been short-lived, and inflation expectations have been mostly modest. Banks have therefore been able to earn a fairly healthy, albeit variable, spread between their assets and liabilities over time.
Unfortunately for banks and their investors, this spread has been falling for a number of years, accelerating in the aftermath of the financial crisis as growth and inflation expectations declined and the Federal Reserve took aggressive actions to lower benchmark rates. Bank profitability is correlated with both the level of short-term rates and the steepness of the yield curve, and detrimental effects intensify in a low-rate, flat-yield curve environment.2 Understandably, investors are therefore concerned about the future path of interest rates and its effects on profitability and valuation.
A Demographic Transition Shaping Rates
We think the key to understanding the current rate environment—and to making reasonable forecasts—is to examine which factors have been in place since real rates began falling at the turn of the century and which are likely to persist over the next five years. We think that three main factors will determine the future course of interest rates in the US and the devloped world. First, the "new economy" characterised by globalisation and technological advancement has changed the need for investment and will continue to exert an effect on the prices of capital and labour.
Second, demographic changes—primarily an aging and longer-lived global population—will change savings and investment patterns. Finally, the state of the credit cycle will weigh on consumer and corporate behaviour, as well.
Many observers attribute the current rate environment to the global financial crisis and assume that as the economy recovers rates will soon return to historical norms. However, we believe this assertion misses the bigger picture. Interest rates have been falling on a global scale since well before the financial crisis. Though real rates peaked in the mid-1980s, it appears that a long period of stability ended around the turn of the century.
