Where are interest rates heading and how should investors respond?
If you are feeling a little confused as to whether equity markets locally and globally are in value or are expensive, then you are not alone.
Warren Buffett commenting at the Berkshire Hathaway AGM recently noted: “Stocks are selling at high prices historically, but you need to look at them in the context of rates… At normal interest rates, stocks at these prices will look very high. But if we continue with these low interest rates stocks will look very cheap.”
Buffett’s argument is consistent with our published views over the last few years. It describes the “investment dilemma” that we outlined in our recent letter to investors. The perception of value at any point is driven by the economic environment, and bond yields – being a proxy for risk free rates – are vitally important.
The following table of the MSCI G7 Index creates a further dilemma for investors. It shows trailing earnings with consensus forecast earnings growth. The key take-outs are the slowing earnings profile of the US, the negative earnings growth of the UK and the projected buoyant recovery in earnings across the Eurozone and Japan.
Figure 1. MSCI G7 Index
Source: MSCI Price Data
One implication of the above is that earnings growth is driven by currency moves. Weakening currencies seem to translate into improved corporate earnings.
What causes a currency to weaken? Economic distress that results in a significant adjustment to cash rates by the Central Bank.
But is a sustained period of low cash rates an economic panacea?
Based on the above, it seems not; and whilst sustained low cash rates seem to stimulate for a while, their longer term effect is muted.
That leads to today’s most important question confronting investors: Where are local and global interest rates heading in the next few years? And why is it important?
Recent global bond volatility is likely a taste of things to come. Whilst bond yields can stay low for a sustained period (particularly noting QE policy), it seems reasonable to forecast that in the medium term (say, 3 years hence) bond yields will be higher than today.
Rising long bond yields currently reflect an adjustment to market opinions on both the suitable risk free rate and the declining risk of deflation as a consequence of quantitative easing.
Over the next 3 to 5 years, it seems reasonable to expect that risk free rates will migrate towards longer term averages. That means that the prices of bonds will correct and fall in value as their yields rise. The question is, will it be a slow and steady progression, or will yields and prices react sharply? In this context, Central Bank policies and actions will be crucial. Their power to manage bond yields and expectations via QE should mean that disruptive price movements will be avoided, but perhaps this is too sanguine an expectation. Central Banks have attempted to manage confidence levels in financial markets and the broader community in the years since October 2008, to varying degrees of success. Now some seven years later, and with work-outs still to occur, should we expect that they would lose control? They are acutely aware that sharp price reactions would shake confidence and increase risk premiums within equity markets.
A question of value
An unprecedented period of low cash rates, QE and historic low bond yields have pushed earnings and equity multiples to levels that suggest markets are over or fully valued. The biggest and best example is the US equity market which continues to push to record highs. But as Buffett warned – if current interest rates are sustained – then stocks may not be that expensive.
Clearly it is low yielding (and in some cases, negative) long term bond yields that are creating confusion in the assessment of value, and encouraging investors to assume more risk across asset classes to chase lower returns. As risk free rates fall towards zero, the natural result is that returns on all financial assets also gravitate towards zero (following an initial “re-rating”). In other words, sustained lower interest rates will likely result in a sustained period where market prices literally mark time.
As is not uncommon in markets, the outlook is uncertain. Will Central Banks hold interest rates at near zero or will bond yields break loose and cause a PER correction? Whilst we suspect that Central Banks will hold interest rate markets where they are for some considerable period, particularly in the Eurozone, it is worth considering various scenarios.
How will the Fed normalise interest rates?
One often cited risk for equity markets is that the US Federal Reserve (Fed) will soon determine that cash rates need to begin a normalisation cycle. What the discussion of this risk generally fails to acknowledge is that the Fed has spent seven years rebuilding the financial system and is unlikely to let that effort go to waste. So it is likely that the lift in US cash rates will occur at a pedestrian rate. Thus a cash adjustment of 0.10% each quarter for say two years would merely take cash rates back to 1% by 2017. Such a strategy fosters the normalisation process, creates certainty and is so slow that it allows corporate earnings to grow at a faster rate than the downward effect of lower PERs. This strategy would pre-empt the Europeans but allow the ECB to complete its QE and thereafter follow with their own normalisation process in two years’ time.
Australia – Has it been so bad?
Key outcomes on sharemarket performance since 2007 are:
- Economic growth +23.5%
- Population growth +13.7%
- Earnings growth +16.4%
- Dividends growth +18.2%
- All Ordinaries Price growth negative 4.8%
- All Ordinaries Accumulation growth positive 4.1% per annum
On reflection, we surmise that the negative market price outcome was due to the 35% overvaluation of the All Ordinaries Index based on intrinsic value. 2007 was followed by a significant correction, where the pendulum of risk appetite swung to the other extreme, providing the best investment opportunities for a generation. Today, the local market is trading around intrinsic value, neither time for alarm or opportunity, on fundamental grounds.
Our suggestions for equity investors in this environment are to:
- Maintain patience and accept that lower returns are likely from stock indices;
- Improve the return from equities by careful stock selection;
- Expect volatility in markets and utilise some trading to enhance returns;
- Assume that interest rate settings will be slow in being adjusted. Global Central Banks have spent far too much time and energy to this point to deviate significantly from current policy settings.