YOUR INVESTMENTS AND THE CHANGING PRICE OF MONEY
With inflation at multi-decade highs in most developed countries, central banks have now entered a rate hiking cycle. This has lifted the price of money, as well as the hurdle for the prospective returns of other asset classes. While we believe these changes have been priced in reasonably effectively by financial markets, there are risks that remain. What does this all mean for investors – how do we position multi-asset portfolios appropriately in the current environment?
After the world emerged from the global financial crisis in 2008 and 2009, short-term interest rates – in effect, the price of money – were kept low in a bid by central bankers to boost the global economy, and as evidenced by sustained growth over the following decade until 2019, this approach was largely successful.
Since the start of 2022, however, the price of money has changed. After years of cheap money, interest rates are rising globally, and since this is the most important determinant of asset prices, it has implications for all asset classes.
FED FUNDS RATE
It all started in the US – since the funds rate of the US Federal Reserve (the Fed) is the baseline off which the rest of the world determines the price of money in various currencies. For readers not well versed in economics, this is due to the position of the US dollar as the world’s reserve currency as part of the 1944 Bretton Woods agreement.
It’s also as a result of perceived security associated with US government debt. The geographic positioning, economic might and military superiority of the US mean it’s the country least likely to be successfully invaded. So short-dated US treasuries carry the lowest default risk. Like it or not, the US sets the tone for global monetary policy.
For 79% of the time since January 2009, the Fed funds rate has been below 1%, and 93% of the time it’s been below 2%. Although the rate is currently still under 2%, we expect this to change in the coming weeks and the futures market is pricing in a rate of 3.5% by the end of 2022.
A key tenet of finance is that the present value of a stream of future cash flows must be viewed relative to the other available options. The Fed funds rate is the foundation for such relative assessment.
For example, from 1980 to 1982, if you lent money to the US government by buying 30-day US treasuries, you would have received around 15% interest per year, risk-free. So, to be enticed to buy any other – by definition, riskier – asset, an investor would expect a higher return to be compensated for the additional risk.
If you wanted to borrow money to open a factory, for instance, you would have had to offer the lenders an interest rate above 15% to induce them to lend the money to you rather than the US government. For it to be worthwhile for entrepreneurs to build factories in 1981, the expected return needed to be quite high, likely over 20%. This meant that relatively fewer factories were put up at that time.
While money was exceptionally expensive over that period, the price of money then entered a multi-decade secular decline, where it became progressively cheaper through lower interest rates. This was, of course, fantastic for economic growth.
During the period from 2009 to 2017 and again through 2020 and 2021, the risk-free rate was below 1% – beating this rate was far less expensive for potential borrowers. Accordingly, many new potential projects became economically feasible, with large corporates often able to obtain long-term debt funding at 3% interest. If you can borrow money at 3%, then a project with an expected 6% return is attractive and likely to be approved.
On a larger scale, stock markets function the same way by offering potential investors the chance to invest their money into enterprises that expect to make profits. When investors’ risk-free alternative is offering low returns, the stock market appears relatively more attractive. This results in prices being bid up, driving expected subsequent returns down. This was essentially the situation from 2009 to 2021, with the exception of the Covid-19 period.
From 1970 until 2008, the Fed funds rate was mostly above inflation, so money had a cost in real terms. Since that time, short-term interest rates have generally been below inflation, so those buying ‘risk-free’ assets were losing money in real terms. This created a ‘there is no alternative’ narrative, driving investors to seek positive real returns through riskier assets, mostly via corporate bonds and equities.
With so much cheap money floating around, inflation was inevitable, but the party continued for far longer than economists expected. Eventually, pandemic-related supply shocks tipped the scales in favour of inflation. With inflation at multi-decade highs in most developed countries, central banks have now entered a rate hiking cycle, which has lifted the price of money.
IMPACT ON INVESTMENTS
The hurdle that the prospective returns of all other assets need to clear has risen, and higher future returns require lower current prices. For the average person, higher interest rates mean that debt – such as home and car loans – becomes more expensive. In 2021, someone who bought a US$500 000 house was paying US$2 100 per month at 30-year mortgage rates of 3%. Now repayments on such a loan are US$3 000 per month.
Looked at from another angle, that US$2 100 monthly repayment will now buy you a US$350 000 house, with rates at 6%. So (unrealistically) keeping everything else equal, US house prices would need to decline by 30%!
In real life, US house prices won’t fall by that much since most homes are at least partially paid off, many homeowners have fixed rates, people are typically not willing to sell for materially less than they paid, and people will look to cut back on other spending to be able to afford mortgage repayments.
The concept is the same for stocks, although the quantum of the change is not quite as brutal as the house price illustration. Most larger asset managers have long understood that rates were artificially low. So the first part of the increase in the price of money from 0% to 1% was essentially ‘free’, as it was already baked into prices.
The second important concept is that higher rates are driven by increased inflation expectations, which would be priced into long-term expected growth rates. Without boring readers with the maths, the jump in the Fed funds rate from 1% to 3%, coupled with an increase in long-term inflation expectations from 2% to 2.5%, should result in a roughly 23% decline in the value of stocks – or a decline in the justifiable price-earnings multiple from 20 times to 15.4 times.
The MSCI World Index is down 21% so far this year at the time of writing, which suggests that the change in the price of money has been priced in reasonably effectively by markets. The remaining risks are two-fold:
The initial level of the market was ‘high’, even relative to the low price of money, which means that there might be more normalisation to come.
The earnings expectations associated with stock prices likely need to come down as consumers are now spending more on debt service costs and therefore less on other goods and services.
Through the cheap money era, there was little opportunity cost of speculating in unproductive assets. Assets that don’t generate income, from cryptocurrencies to cars and art, did well since you didn’t miss out on much by not holding them. This has changed, as is most clearly evident in the more than 50% decline in the price of bitcoin so far in 2022.
At Sanlam Private Wealth, we’ve long recognised that developed market interest rates have been artificially low, which is why our holdings of developed market bonds in our multi-asset portfolios have been much lower than what we would consider a ‘normal’ level.
This has also come through in our stock-picking, where our valuation-driven approach has helped us avoid most of 2021’s overpriced market darlings, resulting in the market declines of 2022 both in South Africa and globally impacting our clients to a lesser extent. This serves as a reminder that the road to market-beating returns is not just about finding winners in the good times, but also about avoiding loss in more difficult times.
The road ahead for the global economy, as well as for stock prices, is far from certain and likely to be rocky. At Sanlam Private Wealth, we remain committed, as always, to our tried-and-tested philosophy and approach, and our long-term investment horizon.