The end of interest rates

Why the return on capital will gradually converge to zero

Entrepreneurs and tech people love to fantasise about the future. How self driving cars will change transportation. How drone delivery disrupt logistics and how bitcoins make sovereign currencies obsolete. But besides dreamful tech fantasies, how will financial markets look like? How will, especially, interest rates and the return on capital develop over the next 50 years driven by technological disruption?

There is substantial evidence that the return on capital (or cost of capital, depending on your position) will converge to zero as the slope of technological progress approaches one.

Return on capital decreases with increasing technological progress

Why?

Technology makes innovation cheaper, making capital abundant

During the industrial revolution it was impossible for a person without substantial capital to start a business. Innovation was asset heavy (mining, steel etc) and thus required a substantial investment. Today, things have changed significantly. It was never cheaper to innovate or to start a business and the result is a rapid increase in the supply of capital. Corporations are pilling massive amounts of cash. Non-financial US companies alone had more than $1 trillion in cash on their balance sheets end of 2014.

The causality is simple: A lower demand for capital means higher supply, which causes lower returns.

Cash balance of non-financial US corporations from 1995–2014 (source: Fed)

Technology makes capital markets and the allocation of abundant capital more efficient

Apart from an increase in the supply of capital, capital is more efficiently allocated driven by information technology. The advent of algorithmic trading and information technology such as the Bloomberg terminal in the 90s made public markets more efficient. Companies like Angellist, Mattermark and Kickstarter will suddenly make the private investment market equally information efficient.

Arbitrage opportunities vanish and more capital is chasing fewer return opportunities, ultimately leading to lower returns.

The trend is already visible in many industries today. A study of the performance of 20,000 US organisations from 1965 to 2010 illustrated that the return on invested capital is today only one quarter of what it was in 1965.

Return on assets for the US economy 1965–2010 (source: Deloitte Shift Index)

The effect of decreasing returns will be even more striking on asset-heavy industries.

Asset-heavy companies will suffer even more under decreasing returns. Capital intense goods and products will be shared more efficiently leading to a lower demand for asset heavy goods. Sharing cars and bikes was a beginning. In the future households are producing and sharing electricity. Companies might even share production facilities, 3d printers or heavy machinery. A more efficient collective consumption of capital-intense goods will free even more capital.

This trend is already reflected in the market value of asset-heavy companies. Returns in asset-heavy sectors such as mining, steel and utilities under-performed asset-light industries substantially over the last decades.

Asset-heavy stocks versus market benchmark (S&P500)

The dilemma of asset-heavy corporations will also be reflected in the way how we asses the value of companies. Hard asset ratios are no longer a proxy for company value in an economy driven by intellectual property, software and brand value. Whereas a huge deviation of the book value of assets to company value (Tobin’s Q) once displayed a market anomaly, will become the standard (look at google, Facebook etc).

Tobin’s Q, ratio between a physical asset’s market value and its replacement valu

However, the deviation of market values from book values is not only driven by shifting capital from asset-heavy to asset-light industries but also by lower returns itself. Today’s high valuations of tech companies (see Uber, Pinterest et al) and the recent stock market boom are not necessarily driven by overoptimistic expectations of future cash flows but rather lower return expectations. Hence, the denominator we use to discount future cash flows becomes smaller, resulting in higher valuations today.

Decreasing entry barriers will accelerate deteriorating returns

Entry barriers have been dropping for years across all industries. Despite the lower capital requirements for starting a business, lower returns work as a self-reinforcing force on even lower returns. Investors and corporates are looking for the last “high-return” opportunities, acting as Adam Smith’s “invisible hand” by entering sectors in which returns are still attractive.

Decreasing entry barriers across all industries are already prevalent today. For example, the life expectancy of firms in the Fortune 500 declined from 75 years half a century ago to less than 15 years today.

Source: Richard Foster, Creative destruction

What are the implications for today’s entrepreneurs?

  1. An increasing supply of capital will make it easier for entrepreneurs to raise capital. Record sums have already been flowing into private equity and venture capital over the last years. (The average VC fund grew by 7x since 1980. Source: US national venture capital association)
  2. Both PE and VC funds will see lower returns compared to historic benchmarks.
  3. The increase in capital and the changing economic conditions will make it harder to forecast market bubbles. (consider the current situation: are we in a bubble or not?)
  4. The pace of innovation will continue to accelerate, making it easier to disrupt an industry but also harder to maintain market positions. Big tech companies such as Google, Facebook and Apple will pop-up and vanish more quickly. (look what happened to the majority of the 10 most valuable public tech companies of 1995)
  5. Apart from outliers markets will become less concentrated with a bigger amount of SMEs.

After all, being an entrepreneur is — most likely — the only way to generate abnormal returns and the timing has never been better.