A confluence of events and policy shifts has coalesced into a unique opportunity for the Canadian government and firms to make long-term strategic investments.
The arrival of inflation-adjusted negative interest rates presents a rare chance for Canadian businesses to invest in their firms and people.
This investment environment demands that firms move boldly to pull forward a decade’s worth of fixed-business investment into the next 12 to 24 months to prepare for what we expect to be a hyper-competitive post-pandemic economy.
So why now, and how does this work?
The cost of new financing will be negative over the life of the debt, assuming positive interest rates of inflation.
The cost of new financing — taken on at today’s extremely low interest rates and then adjusted for inflation — will be negative over the life of the debt, assuming positive rates of inflation.
We show this in the yield curve for Canadian government bonds. Because of the rapid response by the Bank of Canada to the shocks of the trade war and the pandemic, money-market rates are at the zero lower bound and will stay there until a sustainable recovery has taken hold.
In addition, the central bank has continued its asset purchase program, buying longer-term securities and in the process, pushing bond yields to extraordinarily low levels. Given the current 0.7% inflation rate, real (inflation-adjusted) bond yields are negative out to five years’ maturity.
With the yield on Canadian government bonds out to a 10-year maturity reaching 1% in recent trading and with inflation expected to rise as the economy bottoms out, inflation-adjusted yields of government bonds out to a 10-year maturity will also be negative for the remaining life of newly issued bonds. That is, debt issued in 2021 will increasingly be retired in deflated Canadian dollars.
The government can promote economic growth that will pay for itself through higher tax revenues, while creating the platform for the next phase of the digital revolution.
The case for private investing
Given the current shape of the yield curve and negative real interest rates, business investment makes economic sense and will bolster the long-term prospects for firms that have the foresight to act now. Firms must undertake productivity-enhancing investments in 2021 and prepare for the intense competition that will characterize the post-pandemic global economy.
Firms must undertake productivity-enhancing investments now to prepare for intense competition in the future.
We are assuming corporate borrowing at roughly 85 basis points higher than the yield on government-backed securities. Over the life of a $1 million, 10-year corporate bond issued at 1.85%, the interest payments on that bond would total $18,500 per year.
But those payments and the face value of the bond would be deflated by the rate of inflation such that the total cost of retiring the bond after 10 years would be $985,000, assuming the inflation rate reaches the Bank of Canada’s 2% inflation target.
With the Bank of Canada anchoring the front end of the yield curve with a near-zero policy rate, the next few years will be defined by inflation-adjusted interest rates that are negative.
This provides a tremendous opportunity for firms to make transformational investments to complement the new era of technology, telework and automation.
Reaping the rewards
Fortune favors the bold. Now is the time to act. Those firms that choose to invest in their technology and personnel will create the conditions to thrive in the coming economic expansion.
The damage wrought by the pandemic almost assures that monetary policy will continue to be directed at dampening the long end of the yield curve in the coming year.
The banks’ commitment to keeping short-term interest rates at the zero lower bound for as long as necessary, and its amassing of long-term bonds, imply that the cost of borrowing at the long end of the yield curve will remain low in nominal terms and remain negative in inflation-adjusted (or real) terms.
The potential return on investment amid negative real interest rates demands that firms act decisively to integrate advanced technologies into the production of goods and provision of services to prepare for what will be a very different economic and financial landscape than before the pandemic.
Business should consider it necessary to pull forward investments in software, equipment and intellectual property that might normally have occurred over a decade into the next 12 to 24 months.
Furthermore, the decrease in personal consumption during the pandemic suggests a surplus of pent-up demand waiting to be unleashed on the local economies and the global supply chains that support them. Canadian firms should make it a point to meet that rush of consumer spending.
The case for government spending
There are several things to keep in mind when considering additional government spending and the inevitable calls for fiscal discipline.
The first are the historical examples of the U.K., where growth deteriorated during its era of austerity over the past decade, and the United States, where the working class was left behind by decades of outsourcing, automation and the digitalization of the economy.
In Canada, we anticipate further displacement in the workforce as the economy moves beyond resource extraction. There will be a need to provide programs for the pipefitters and rig workers who powered the economy during the postwar industrial era but will find themselves out of work.
Second, pandemic relief packages are necessary to keep families, businesses and the economy afloat during what could turn out to be a multiyear emergency. While income relief is the essential element in propping up consumer demand, it is not an infrastructure program and falls short in preparing the economy for the future.
Though it is perfectly logical for the government to address the immediate problems of the pandemic, it could become politically difficult to find acceptance for infrastructure spending once austerity urges set in again. This is not the time to wait and see what happens.
Within an increasingly global economy, countries need to build the physical infrastructure required for the free flow of business and invest in the framework for an educated workforce that can adapt to changing technologies.
The accumulation of debt is an investment in the future — a bet on the economy and building new income streams. In that regard, it should be the obligation of the government to create the foundation for the next phase of sustained growth.
For more information, visit rsmcanada.com.