Low interest rates may be celebrated by those with mortgages, but can be a worry for those with money in bank deposits. Central banks around the world are lowering interest rates with the objective of stimulating economies, to offset slowing economic growth rates. According to the NY Times, over 30 central banks have cut interest rates this year, and many parts of the world are now experiencing negative interest rates. It appears likely we will be living in a low interest rate world for some time to come and in this article we explain what these lower interest rates mean for investing.
Lower interest rates generally support asset prices whether it be equities, bonds, or property. Investing guru Warren Buffett was quoted as saying ‘Interest rates are the gravity on stock prices’ and ‘assets are worth more when interest rates are near zero’. This means the higher interest rates are, the stronger downward pull they have on share prices and vice versa.
Lower interest rates increase investor demand for alternative higher risk investments as returns on their bank deposits decline. Many retirees need to earn more on a portfolio than most interest rates around the world are currently offering, so they are forced to invest in other assets such as shares to chase higher returns. This has been referred to as TINA – There Is No Alternative.
Using the example of residential property – if you have $40,000 of surplus cash to spend on interest payments per annum and you can borrow at a mortgage rate of 5%, then you can afford to borrow $800,000. If that mortgage rate declines to 4% you can borrow $1,000,000. Therefore, all else being equal, you may be inclined to pay more for a property given lower borrowing costs.
A similar logic applies to other assets such as shares. We used to be able to buy a stock paying a dividend yield of 5% but share prices have moved 20% higher, meaning we will now only get a yield of 4%. While some will argue that stocks now look expensive because the Price/Earnings multiples have gone up, other investors will find a 4% dividend yield still very acceptable in a low inflation world, especially when the NZ Official Cash Rate (OCR) is 1%. A 4% dividend yield becomes more attractive to investors when the cash rate is 1%, compared with when the cash rate is 4%. The chart below shows that the NZ share market forecast dividend yield (blue line) has declined as share prices have gone up over the last 5 years. However, the risk-free rate as represented by the NZ 5 year government bond yield (orange line) has declined significantly more, meaning you now get 2.5% more from NZ dividend yields (before allowing for tax credits that many NZ dividends carry) than government bond yields. On this measure of yield differentials stocks now look cheaper compared with interest rates than what they did five years ago even though share prices have gone up. This demand for yield has helped our investments, particularly in some of New Zealand’s high yielding sectors such as the utility companies.
Another reason low interest rates support share prices is that analysts will make projections for earnings and dividends and then discount those future earnings back to today’s value using a discount rate which is directly linked to interest rates. These are known as DCF (Discounted Cash Flows) and DDM (Dividend Discount Model) valuations and the lower the discount rate you use, the higher your valuation.
The examples above illustrate that low interest rates do positively impact asset valuations. However, we must remember the reason interest rates are coming down is due to lower economic growth (not helped by trade wars) which will adversely impact company earnings, so we can never just look at interest rates in isolation. There are many variables we must take into account when investing, and interest rates are an important one of those.
Disclaimer: This article is intended to provide general information only. It does not take into account your investment needs or personal circumstances. It is not intended to be viewed as investment or financial advice. Should you require financial advice you should always speak to an Authorised Financial Adviser.