Jeremy's Blog 12th August 2022: Interest Rates - Time and Risk
This article by Jeremy Moody first appeared in the CAAV e-Briefing of 11th August 2022
After more than decade of unprecedentedly low figures, interest rates with their relevance to valuation are again at the centre of economic and political debate, bearing on valuations both in the market place and informing choices of discount and capitalisation rates. Like trade and despite utopians, a price for using someone else’s money, making their credit available, seems innate human behaviour. The actual rate is then a price for several things.
In the market it is the price at which the supply of money for lending balances with the demand for it, influenced by confidence in transactions and their ease. Rates have fallen over the last eight centuries as money markets became deeper and more global, as credit is easier to check and as financial instruments have developed. On this approach, low rates now reflect a glut of savings by an aging world population struggling to find opportunities. The price helps allocate resources, supporting innovation, productivity and growth.
Fundamentally, the rate is the price of time. With Adam Smith’s “Consumption is the sole end and purpose of all production”, Why lend at all rather than spend now? What is the price for a borrower to persuade a lender to make money available now for a later return?
Both imply pricing for risk with higher rates for riskier ventures, illustrated by the growing spread between Italian and German 10 year bonds, now 2.4 per cent compared to October’s 1.2 per cent while tertiary property trades on higher yields than prime property. As securing lending on property reduces the lender’s risks in a loan, agricultural land with low loan to value ratios typically sees lower rates.
More deeply, this recognises uncertainty – few priced for the scale of Russia’s war on Ukraine, now thought to cost $1 trillion of world growth this year. The unknowns of Taiwanese microchips, Chinese property and debt, the cost of the retreat from globalisation, US politics, Germany without gas all join possible pandemics, seismic and Carrington events and climate change for this – with who knows what else. The longer the time, the less is knowable. 20 per cent of even triple-A rated firms in the US Standard and Poor’s 500 index go bankrupt over a century.
This has been overlaid by interest rates’ use as a tool for managing the economy, to ease or squeeze demand, successively for the exchange rate, employment and inflation. Ultra-low rates (negative on the continent and Japan) were applied with quantitative easing to ease the shocks of the financial crisis and the pandemic. While sustaining confidence, they have boosted asset prices, under-priced risk and neither they nor the present tax structure have improved business investment. These tensions now come to the fore, exposing imprudent investment, poor businesses and companies and governments overloaded with debt finance.
As 13 years of rates below 1 per cent and the “new normal” recede, the wind of change asks us to think harder about risk and reward in assessing values as we re-price a poorer economy in a risk-shy society. The investor Warren Buffett noted that “Only when the tide goes out do you discover who’s been swimming naked” while Kipling observed:
“That all is not Gold that Glitters, and Two and Two make Four –
And the Gods of the Copybook Headings limped up to explain it once more.”