In a three-part series, investment and advisory group Jarden explores three key factors at play in investment decisions in 2021. In part three, Jarden CEO James Lee and director (institutional equities) James Bascand explain explain the impact of low interest rates on the markets.
We have previously discussed key changes to markets — from the evolution of passive investing to the new type of retail investor entering the market — but the final element that ties everything together comes back to the core foundation: interest rates.
When thinking about the historic and future performance of capital markets, interest rates may be the most important driver — and one of the hardest to predict.
Notably, the New Zealand equity market is more linked to interest rates than many other global markets. Our significant exposure to large dividend-paying utilities (the electricity generator/retailers, Auckland Airport, and even Spark NZ), as well as a few large growth companies (Fisher & Paykel Healthcare, Mainfreight, and The a2 Milk Company) suggests investors should be aware of movements in rates.
As interest rates fall and it becomes harder and harder to live off returns from term deposits or other fixed rates, investors have tended to look to sustainable dividends available in equity markets — and utilities often offer a lower risk dividend outlook.
Growth companies present a different relationship to rates. When the market assesses the value of growth companies, it often looks years into the future, trying to forecast the profits and cash that growth companies may be able to produce.
Clearly there is an opportunity cost in buying something today that is expected to grow in the future, so capital markets typically discount future earnings to what is a fair value for them in today's money, given the risk they are taking on a given investment.
Broadly speaking, the key variable when assessing value in today's terms is the interest rate you assume, and the cheaper you can borrow money, the lower the future returns you require as an equity investor. Essentially, lower interest rates increase the value that an investor is typically willing to pay for future earnings growth.
As rates fall they exacerbate asset prices. When they move rapidly from extremely low levels, the percentage movement can be massive, either creating or destroying value in a way that we have experienced recently.
Even before we consider that lower rates allow us to take advantage of increased access to borrowing, rates are so extremely low right now that we can't ignore the fact that this has turned the average central banker into a modern-day Loki — the god of mischief.
Historically, a central banker, if so inclined, could choose a few careful words and rates would move up or down by 0.25 per cent. When rates were 6 per cent, that move didn't matter a lot.
But today, with rates close to zero, an 0.25 per cent swing is significant relative to the starting point. In fact, at the moment it's the difference between the NZ official cash rate (set by the RBNZ, and which informs or influences all other rates) falling by 100 per cent to zero, or doubling to 0.5 per cent!
Take this example. If you could afford to pay $500 a week for your mortgage, that equates to $26,000 a year in interest payments, without paying off any of your principal. That means that when interest rates were 8 per cent, you could afford a $325,000 home.
But when rates hit 2 per cent, you could afford a $1.3 million home. What really happens is that the average $325,000 home now becomes worth over $1 million, given that's what people can pay for it.
The question is, what happens when rates go back to 4 per cent? Will that asset be worth half of what it was?
Now, it is never as linear as that. Asset prices have a lot of different inputs, but we can't ignore the fact that property prices and asset prices are directly correlated to interest rates.
Looking at it from a stock perspective, Spark's dividend is 25 cents per share, and has been since 2016. However, the share price has increased from $3.30 per share to a high (in August 2020) of $5.09 as New Zealand's 10-year interest rates have fallen from 3.4 per cent in January 2017 to a low of 0.45 per cent in September 2020 before rallying to almost 2 per cent last month and currently trading near 1.6 per cent.
Spark has fallen from its highs to $4.40 per share at the time of writing, as its dividend yield suddenly looks less attractive relative to the higher interest rate backdrop.
The key takeaway here is that the sensitivity to low interest rates has the potential and precedent to create extreme increases in volatility for income stocks, property prices and for much of the overall market.
Rates will rise one day — maybe not for a few years, but 2 per cent mortgages aren't sustainable. What these low rates have done is push capital further up the risk curve to find returns.
Wrapping up 2020, the key factors include:
• Passive money flow into new products (including exchange-traded funds) dictating short-term movements;
• New investors spending their entertainment dollars on trading names they are familiar with;
• And interest rates so low they are encouraging people to invest.
The good news for active investors is that trading with full knowledge of the three factors we have discussed over the past month or so will have presented an opportunity to generate returns. It is hard to see why this will change.
In fact, the volatility that these factors introduce may intensify under periods of market stress (good or bad), so as the year rolls out, all we can do is accept that markets will continue to move around quickly.
Over the years we have met many smart people who can convincingly argue that one of these factors is a bad thing or good thing. What we have learned over the past year is that they exist, and we are better to understand them and make them part of our decision-making process rather than disagree with the merits of their impact.
The best advice we have ever received, when it comes to markets, is to be very thoughtful if risking more than you would feel embarrassed telling your parents, significant other, or the courts about if you lost it.
READ MORE FROM THE SERIES:
- The information and commentary in this article are provided for general information purposes only and does not constitute financial advice. We recommend the recipients seek financial advice about their circumstances from their adviser before making any investment decision or taking any action. For information about Jarden's financial advice service, please refer to our publicly available disclosure statement which is available on our website at www.jarden.co.nz.