The mysterious death of the market rentier

The traditional rentier who wants to live on safe returns from their capital will find it hard to survive the 21st century. Photo / 123RF

A financial whodunnit with momentous investment implications for the young and old.

It is a setting worthy of Agatha Christie. The corpse of a thrifty pensioner is lying on the floor of a country house, shot through the head, the fingers of one hand wrapped around the butt of a revolver and a bank statement clutched in the other. The cause of death is obvious. But who fired the gun? Was the small saver murdered? Or did she pull the trigger herself?

That is the question raised (metaphorically) by the economists Joseph Kopecky and Alan Taylor in a recent paper called "The Murder-Suicide of the Rentier". It tries to untangle why risk-free interest rates have collapsed during the past couple of decades, and finds an answer with important implications for both the economy and the returns that stock market investors can expect in the years to come.

The title of their paper is a play on a comment by John Maynard Keynes, who predicted, in 1936, the "euthanasia of the rentier". As technology advanced, populations declined and the capital stock grew larger, Keynes imagined that interest rates would dwindle to the point where rentiers — traditional coupon-clipping investors, living off interest in their country homes — could no longer survive.

It certainly seems as if that moment has now arrived. Any hope of meaningful income from bank deposits or government bonds had vanished even before the Covid-19 crisis. Interest rates were negative in many countries, and there was growing concern about the possibility of "secular stagnation".

According to work by the economist Kevin Daly, however, there is a puzzle about this downward slide in returns. Since the early 2000s, the earnings yield on equities — which is a company's earnings per share divided by the share price — has not fallen as much as the yield on risk-free bonds. In other words, the equity risk premium — the additional return earned by investing in stocks over risk-free government bonds — has gone up, by 2.5 percentage points on Daly's estimate.

The question is: why? A simple rise in savings compared with investment cannot explain why the relative returns on different assets might have changed.

One possible answer is the global savings glut, first pointed out by Ben Bernanke in 2005. If Asian central banks with huge stockpiles of reserves are determined to invest them only in risk-free assets, their demand might push down the return on government bonds relative to equities.

Prof Kopecky and Prof Taylor have a different theory: population ageing. As the baby boomers born after 1945 neared retirement, they began to convert holdings of equities into safer bonds, pushing bond yields down and holding equity yields up. That means it is not an overall glut of savings that drove interest rates so low, but a falling appetite for risk.

The rentiers were therefore not killed by outside forces such as technology — they did it to themselves. A related factor may be tighter rules on defined benefit pensions, where a push to match assets with liabilities has led many to shed equities and buy bonds.

Population ageing in rich countries is set to continue for decades to come: it is one of the defining phenomena of our time. If this theory is correct, therefore, the equity risk premium is likely to remain high in the future. Prof Kopecky and Prof Taylor's model suggests that the risk-free rate of return on government bonds will fall to minus 2.8 per cent by 2050, but the return on equities will be 2.2 per cent: a risk premium of 5 percentage points.

This has several implications. First, it may help to explain why investment has been weak despite ultra-low interest rates in recent years. Businesses cannot borrow at the risk-free rate; they need equity or risk capital to invest in new factories or new products. If the risk premium has risen even as the risk-free rate falls, then such capital may not have become much cheaper.

Second, it means a significant equity risk premium is available for those willing and able to capture it. That is particularly good news for anybody who can borrow at close to the risk-free rate and then invest for long enough to wait out volatility in equity returns. Perpetual university endowments are one obvious candidate; sovereign wealth funds are another.

It also offers some hope for young savers, although it is important to note that a high equity risk premium does not imply the equity market is undervalued. Rather, it suggests that the average return on equities, over long periods of time, will be significantly higher than the risk-free rate. (The short and medium-term path of the stock market is, as usual, anybody's guess.)

Last, a high equity risk premium combined with ultra-low risk-free rates is bad news for older savers and anybody else who cannot take risk. For pensioners, the painful choice between pitiful rates of bank interest on one hand, or risking a stock market plunge like that in March this year on the other, is only going to get worse. It may also contribute to inequality, since it is those with greater wealth who are better able to find and hold on to risky investments.

Like the Agatha Christie country house, the traditional rentier who wants to live on safe returns from their capital will find it hard to survive the 21st century. For those who can tolerate some equity volatility, however, the growing ranks of the risk averse will create opportunity.

Written by: Robin Harding
© Financial Times