The True Cost of Cheap Debt

Faris Lee’s Rick Chichester believes the U.S. economy may have a stiff price to pay for the low interest rate environment that has continued well after the recovery.
Unemployment is low. Consumer confidence is high. The Dow is around 26,000, interest rates remain at historic lows, and the Federal Reserve has paused. America is in a low inflation rate environment, and things couldn’t be better. Right? Yes and no, says Richard Chichester. The president and CEO of real estate investment advisory firm Faris Lee believes there are pluses and minuses to what is seemingly an ideal economic environment.

“The current environment of low interest rates that we’ve lived in since the Great Recession has certainly provided benefit to the economy, albeit while undervaluing risk,” he says. “Having a lower cost of capital in terms of debt frees up the spending capabilities of consumers and companies. This gives confidence to the consumer that they feel good about their abilities to spend on wants and needs.”

Creating Consumption
Jobs and wages continue to grow and debt remains cheap. This has inspired many Americans to spend — and spend, they have. U.S. retail and food services sales totaled $514.1 billion in March, according to the Census Bureau. This was a 1.6 percent increase over February and a 3.6 percent increase from one year prior.

“In the aggregate, the amount of debt has increased while the cost of that debt has decreased, resulting in still manageable levels of debt service,” Chichester explains. “Meanwhile, employment has strengthened considerably, wages have increased moderately and assets, especial the equity market, have experienced new highs. In total, this combination is very favorable to the consumer.”

It’s also very favorable to retailers. Not only are consumers spending, but this extremely low cost of debt essentially subsidized by the Federal Reserve’s monetary policy also provides an opportunistic business climate.

“The benefit for retailers is that most businesses operate on debt,” Chichester continues. “They now have the ability to fund their debt to manageable financial levels. They can increase the aggregate dollars of debt and still maintain a low debt obligation. Having ‘cheaper money’ provides greater resources for a company to expand and/or invest and be more strategic and comprehensive in their business growth.”

Chichester also believes this climate is hospitable to shopping center owners.

“From an investment standpoint, low interest rates provide opportunity to take advantage of cash flow or yield produced off the property and obtain positive leverage on that income,” he asserts. “Relative to the low cost of debt, the low-rate environment allows an operator to leverage up their yield. A stronger economy and interest rate environment help support strong consumption.”

Too Much of a Good Thing
The Fed instituted this low-rate environment to spur spending and bolster confidence in the midst of the Great Recession — and it did just that. Unfortunately, the market has gotten spooked every time the system has attempted to raise rates to neutral, which is needed to maintain the economy’s overall health and viability. The Fed’s last hike occurred right before Christmas 2018 when the target range for the federal funds was between 2.25 percent to 2.5 percent, placing rates at their highest levels since 2008. Consumers responded negatively and the stock market took a hit. This caused the Fed to pull back and declare no further hikes for the foreseeable future, which Chichester believes will extend until fall 2019 at the earliest or, more likely, the first or second quarter of 2020.

Extended low interest rates may be good for buyers, but Chichester believes what was meant to be a temporary stimulus to spending has become a crutch that may have overstayed its welcome.

“This low-rate environment concerns me because this was originally considered to be only a stimulus,” he says. “It’s analogous to medication. You take medication to alleviate a symptom and reduce pain and accelerate healing. But if you take it for too long it risks impacting your long-term health. The monetary policies that have provided for extremely low rates weren’t intended to become a foundational part of our economy. They were intended to be a short-term stimulant for growth.”

The low-rate environment was meant to alleviate the near-term symptoms of a contracting economic condition. It was never meant to become the new normal. Keeping rates low for too long only kicks the can down the road.

“The downside to the low interest rate environment is it has a risk of creating an asset bubble,” Chichester explains. “Low interest rates have created a hyper increase in value, creating historic valuations that can only really be justified by low cost [of capital].”

Taking Your Medicine
Chichester’s solution comes with a dose of tough love. He believes we need to move the inflation rate to a healthier number and raise rates before another hurdle hits the economy and we have no more runway to spare. This is because the current tools available to the Federal Reserve and government are very limited in terms of managing another economic contraction or recession.

“The inflation rate is currently running at less than 2 percent, which means the real cost of the Federal Reserve Rate is close to zero,” he explains. “The Fed needs to raise rates to have ammunition available if — or when — the market contracts. If they can’t do that before the market contracts, we’ll have to go into negative rates and that would be significant and add real challenges to the overall health of the economy.”

Though the U.S. is currently the healthiest economy in the world, Chichester points to Japan as a cautionary tale of how easily the mighty can stumble in this type of climate.

“Japan has been in a zero or negative rate environment for the better part of 20 years,” he says. “This is an example of an economy that was once extremely robust but is now growing very moderately due to these issues.”

While it’s true raising rates may not be popular among those who want to continue to benefit from cheap money, all good things must come to an end. Chichester worries that the country is trading near-term economic health and prosperity over long-term health, prosperity and growth.

“A sustained low interest rate environment is not sustainable and it is not responsible,” he says. “We’re at a point where we have to make hard financial decisions. Kicking the can down the road is not a good strategy and we need to make sure we keep politics out of the process. The longer it takes us to address and manage these realities, the more severe the consequences will be when we get to a period of contraction.”

And what might bring on that next period of contraction?

“The next recession is going to be credit-related,” Chichester emphasizes. “But for now, 2019 is robust, the economy is strong and the consumer is feeling empowered.”

— By Nellie Day. This article was written in conjunction with Irvine, Calif.-headquartered Faris Lee Investments, a content partner of Shopping Center Business.

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