- Era of zero interest rates and free money is over – and now the hangover is starting as the party ends
- Central bank interest rates influence the return available from lower-risk asset classes such as cash and bonds
- Ten-year government gilt is seen as the risk-free rate and any other investment should return more than that to compensate for the additional dangers
- The higher the gilt yield goes, the less inclined or obliged investors will feel to take risk and pay up for other asset classes, such as shares (and vice-versa), so rates affect the P in the P/E (price to earnings ratio)
- The cost of money also affects activity in the real economy – and therefore corporate earnings, or the ‘E’ in the P/E ratio
- All eyes are now on the Fed and Bank of England meetings on 22-23 March
“Two crypto-specialist banks, Silvergate and Signature, have either been liquidated or folded, and Silicon Valley Bank has collapsed within a year of the US Federal Reserve deciding to end its experiment with ultra-low interest rates and Quantitative Easing. As the tide of cheap liquidity flows out rather in, now investors are in the process of once more discovering what risk really means,” says AJ Bell investment director Russ Mould. “SVB was a poorly run bank that took a lot of risk by specialising in one sector. It held its assets in long-dated Treasuries when its liabilities (deposits) could be withdrawn immediately and grew at a meteoric rate when money was at its cheapest, to provide an extreme example of the old saying that ‘bull markets end when the money runs out’.
“Except on this occasion, the free money party was simply huge, thanks to more than a decade of zero interest rate policies (ZIRP) and Quantitative Easing (QE), tools which were wielded with even greater vigour by central banks during the COVID-19 pandemic and lockdowns. Now central banks are hiking rates and tentatively withdrawing QE, the post-party hangover is beginning.
“SVB is a case study in point.
“The specialist in providing financial services to tech entrepreneurs boomed during the 1998-2000 technology, media and telecoms (TMT) bubble and then survived the 2000-03 bust (albeit after a major share price collapse).
“The boom was even bigger in 2000-2021 and it now looks like the fall from grace will be all the harder this time, to perhaps raise questions over other (speculative) asset classes which thrived thanks to the colossal fiscal and monetary stimulus applied during COVID and lockdowns, and which may now struggle as the stimulus is withdrawn.
Source: Refinitiv data
“The return available on cash, and by extension the risk-free rate available on government benchmark bonds, sets the reference point by which the attractiveness, or otherwise, of all asset classes will be judged.
Source: Refinitiv data
“For much of the past decade, bullish investors have argued that share prices should rise because record-low interest rates and record low government bond yields, thanks to Quantitative Easing, mean that ‘There Is No Alternative,’ or TINA. To try and get any sort of return on their cash, they had to look to different, riskier assets.
“The test now is whether higher returns on cash and higher government bond yields tempt them to take less risk and pay lower valuations and prices for riskier assets, because they may feel they do not need them quite so badly. Some strategists are now saying that TIARA is the order of the day – ‘There Is A Real Alternative’ to equities, in the form of cash and bonds, now that returns on them are more competitive.
“However, inflation must remain a consideration here, as it still outstrips returns on cash and bond yields, while tales of investors ‘going to cash’ are misleading. If someone sells a share, someone still must buy it and hand over their cash in exchange. The shares do not disappear, so there is no wholesale movement from one asset class to the next. Instead, there is a relative movement in intent and desire, as reflected in the higher or lower returns that the investor is prepared to accept in return for exposure to that asset class, be it cash, bonds, shares or something else.
“This also helps to explain why the debate over when central banks will pause or pivot on their interest rate increases, and Quantitative Tightening policies is so important. The thinking is clearly that share prices will start to surge once there is any hint of rate cuts or a return to Quantitative Easing, while a period of higher rates than expected for longer than expected, should inflation prove sticky, could well have the opposite effect and drive share prices lower.”
The risk-free rate
“The yield offered by a government-issued bond is usually seen as the risk-free rate for investors in that country because, in principle, the government will not default on its liabilities – the last time the UK defaulted was 1672 with the Stop of the Exchequer under King Charles II. As such, the ten-year UK government bond, or gilt, is seen as the risk-free rate for UK investors.
“It will always be good to make the interest payments (or coupons) on time and return the initial investment (or principal) once the bond matures, even if it must print money to do so.
“Bear in mind that the yield on the bond will differ from the coupon, or interest rate, at its time of issue. This is because the bond’s price will move over time. The running yield of the bond is calculated by dividing the annual coupon by the current price and expressing that as a percentage. The yield to maturity will adjust for any capital gain or loss after the purchase of the bond, since it will usually be redeemed upon maturity at its issue price.
“At the time of writing, the ten-year gilt is yielding 3.48%. This is therefore the minimum nominal return on any investment that any investor should accept, since it is seen as risk-free (despite the tiny chance the UK does default, and despite other challenges posed by movements in interest rates and inflation).
“Any other alternative investment carries more risk so the investor should demand more from them:
- Investment-grade corporate bonds should yield more than government bonds because companies can and do go bust and management teams can do silly things.
- High-yield (or junk) corporate bonds should yield more than investment grade bonds because these firms are more indebted, and the risk of bankruptcy and default is higher.
- Shares should offer the prospect of higher total returns than junk debt, because share prices go down as well as up, while a junk bond will offer pre-determined interest payments and return of the initial investment if all goes well.
“The returns demanded by an investor to compensate themselves for the (additional) risks involved will therefore, in theory, move relative to the gilt yield and that in turn will be influenced by central bank-approved interest rates.
“If a central bank is raising interest rates, then the yield on existing government paper will look less attractive. Investors will sell them and look to buy newly-issued gilts, which will have to come with a higher yield to attract buyers and help the government fund its spending needs.
Source: Refinitiv data
“This increase in yields on government debt means the returns that investors should demand from other, riskier options, should also increase. This means a higher yield on newly-issued bonds or paying a lower price for existing bonds (as a lower price means a higher yield for bonds, just as it does for shares).
“For shares, it means paying a lower valuation, or multiple of earnings and cashflow, and also perhaps demanding a higher dividend yield (which is achieved by buying at a lower share price).
“Remember that the total return from a share is determined by capital return plus dividend yield and the capital return will be, in crude terms, the function of both earnings growth and the multiple paid to access that earnings growth. In its simplest form, this can be seen in the price/earnings (PE) ratio. Earnings will go up (or down), depending upon the business cycle and the company’s target industry and acumen. The price, or multiple, paid can be affected by many things, including the company’s finances, managerial competence and governance, as well as the predictability and reliability of its operations and financial performance.
“Interest rates will have a big say, too. If rates and gilt yields are rising, investors may feel less inclined or obliged to take more risk with shares and other asset classes if safer options are offering better returns, at least on a pre-inflation basis. As a result, they may decide to pay lower prices and multiples – a lower P for the E – and that is why stock markets can slide as rates rise, especially because someone still has to hold the shares. They do not just disappear, so the new owner has to make a judgement on what they are worth.
“For property, the same calculation will apply – the rental yield will be benchmarked against the safer options, in nominal terms at least, of cash and gilts and other bonds. New buildings will need to offer a higher rental yield to attract buyers, and that often means lower property values.”
The discount rate
“There is another way in which interest rate movements affect share prices and equity valuations and this is the more complicated version of the PE ratio. This is the discounted cash flow (DCF) calculation.
“Such a valuation approach is not necessarily suitable for, or at least easy to apply to, all companies, as some have business models and revenue and cash flow streams that are very volatile, or at least cyclical.
“DCFs tend to be used for companies that have relatively predictable cash flows, or long-term secular growth prospects. They are also used for young, early-stage firms that are seen as capable of generating profits some way out into the future.
“There are many moving parts to a DCF, including assumptions about the long-term operating margin, capital investment requirements and terminal growth rate of a business, while a further key input is the assumed cost of the company’s funding (be it debt or equity) and the discount rate. The discount rate is used to value the future cash flows in today’s money, by discounting back those expected cash flows at a given rate.
“The greater the uncertainty over the value of the forecasts the higher the discount rate, and the higher interest rates and gilt yields go, then the higher the discount rate will go too.
“And the higher the discount rate, the less the future cash flows will be worth in today’s money. That means a lower valuation for the equity and a lower theoretical share price, although the opposite holds true, too – the lower the discount rate, the higher the equity value and the higher the theoretical share price.
“This may be why a lengthy period of low or even negative bond yields prompted a huge uplift in the valuation of perceived growth companies, such as tech and biotech stocks, during the past decade (and especially in 2020 to 2021). The problem now for holders of this sort of company is that the opposite effect is kicking in, at least for now.”
