BackInterest rate is not the key driver of investment
Sloan School of Management's S.P. Kothari talks about corporate investment and behavioural finance
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It is widely believed that investments by the corporate sector depend on the rate of interest in the economy—lower the interest rate, higher the investment and vice versa. Though the argument sounds compelling, it may not necessarily be true. S.P. Kothari, deputy dean and Gordon Y. Billard Professor in Management, Sloan School of Management, Massachusetts Institute of Technology, says it is profit outlook which determines corporate investments, and not the small changes in interest rates. In an interview, he also speaks about how corporate investment affects stock returns and behavioural finance. Edited excerpts:
Are stocks overvalued in the US market?
The corporate sector has done quite well and earnings are at a record high. The P-E (price to earnings) multiple is, in part, a function of discount rates and the interest rates are at rock-bottom. That said, whether the market is somewhat frothy; this kind of prediction business is challenging and all kinds of great people have had to eat their words for making predictions about where the market is headed. But market does seem priced rather high right now. I am not trying to make a prediction that it will fall, but it does seem, by historical standards, that it is quite pricey. But there are reasons to believe that the valuations should be fairly high because earnings are quite high and the corporate sector has become more efficient… Many firms have Asian and Latin American operations and those regions are doing well. Some of the earnings stream that we see is reflecting the growth prospects of these companies’ operations that are outside of the western world.
You have said in one of your papers, The Behavior of Aggregate Corporate Investment (2013), that corporate investment is unrelated to change in interest rates. Is it safe to conclude that interest rates do not affect investments?
The evidence is rather compelling that interest rates are not the key drivers of investment. The theory is pretty solid that the higher the interest rates, lower is the investment and, conversely, lower the interest rates, higher the investment. Economic intuition also says that better the opportunities, or the outlook, greater the investment. Where the economic theory is somewhat silent is the relative importance of the two. And there the evidence is helpful in shedding some light on our understanding of, relatively speaking, which of the two matters, or do they both matter substantially.
The answer is, it is the profit outlook that influences investment decisions far more than a percent or two up or down in interest rates.
Even survey data of corporate managers shows that they say if you lower the interest rate by 50 basis points or by 1%, we are not going to increase our investments. We worry more about what the climate is; what kind of opportunities exists. In that spirit we conclude that corporate investment is far more responsive to the outlook or the investment climate, as opposed to some modest changes in interest rates. We are not commenting on 5% change, but most of the changes are half a percent, 1% or 1.5%. Things don’t change dramatically with those nudges in interest rate movements. Case in point, look at the Western world. (Ben) Bernanke and Janet Yellen (respectively former and current chiefs of the US Federal Reserve) have brought interest rates to zero for the past six years, and a consistent complaint in the marketplace has been that the opportunities, the climate and the economy are not good enough for making large amounts of investments. That is why every trick in the book has been used to get corporate sector to invest heavily.
But your observation, in a sense, puts a question mark on the central banks’ ability to influence business cycles.
There is excessive fixation on interest rate policy or monetary policy. It’s important and it is easy to mess things up by having monetary policy that goes awry. We should give a target to the central bank for inflation and let them work on that, but in the overall scheme of things, that’s not the nirvana solution that gets the economy out of the woods. I always give the example of Sweden. It is a great country and it has done well. Do we sit back and say that they are great because of their interest rate policy or monetary policy? No, that’s not what we say.
What is the relationship between corporate investment and stock returns?
Investment responds to corporate profits heavily. So, when profits are high, managers start to invest a lot. But too much of a good thing can be bad also. They go too far and they react too much to that good outlook; they get overconfident, perhaps, and make too much investment and the stock market reacts negatively to that. The stock market recognizes that the managers might have gone too far and extrapolated their earnings expectations too much, and it responds somewhat negatively to those excess investments.
You have written papers in the area of behavioural finance. Is there a way by which individuals can actually overcome biases?
There is no doubt that we individuals suffer from certain biases. Education, discipline and fear of being punished helps us control some of them but not eliminate them. For example, one of the behavioural bias is that managers may get overconfident. How do we control that? We won’t be able to make the manager less confident, but we might be able to put a governance system in place that is not perfectly correlated with that overconfidence, and that might help soften the adverse effects. Overconfident mangers might be hiring too many people or investing a whole lot—there are a number of things that they might do because they have been successful, they have become overconfident and want to take decisions.
If the governance system tries to put some breaks on that, it would be helpful. Again, we may not be able to eliminate it, but we might be able to temper it.
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