In an article posted a little over 12 months ago, Inflation watch, I described the bond market as the “all-seeing eye”, noting that the bond market was signalling a potential incoming spike in inflation. The events of late 2021 and early 2022 have justified the bond market’s concerns. What now? As an investor, what sort of impact can you expect higher degrees of inflation and rising interest rates to have on your investments?
Inflation and interest rates
The problem with inflation lies less with rising prices in standalone, and more with what needs to be done to combat those rising prices. For example, if you’re a Microsoft and you sell a laptop for $2,000 in year one but experience inflated costs to the tune of 5% in your production process in year two, you may eventually hike the price of the laptop to $2,100. Assuming wages grow in tandem (lol), you may be able to get away with this. The bigger problem for Microsoft is what the Federal Reserve must do to fight inflation – hike interest rates (relatively aggressively too). Importantly this inflates Microsoft’s borrowing costs which puts further upwards cost pressure on the supply side. Separately, interest rates and bond yields are factored into a company’s cost of debt when preparing valuations using models such as discounted cash flow. The higher those rates and yields, the larger the impact on valuation.
It’s no surprise therefore that literally every stock market index in the world is down this year. The S&P 500 which peaked in January 2022 is down almost 20% to date and the Nasdaq Composite which peaked in November 2021 is down almost 30% to date (the latter I would point out is a slightly steeper drop than the peak-to-trough fall of the covid-19 pandemic). Tech companies in particular are especially sensitive to interest rate rises because the discounted cash flow model we touched on above discounts cash flows over a longer period of time to factor for the potential exponential growth a tech company may experience. Where to next for stocks? Who knows. But do keep in mind that stock markets are forward-looking. Therefore, stock markets have already priced-in the impact of expected interest rate rises and the expected pace of interest rate rises. Should the Federal Reserve signal a more aggressive policy, there could be further valuation adjustments.
Bonds are supposed to act as a bit of a safehaven from falling stocks. The founder of Vanguard, Jack Bogle (and countless other financial commentators and academics) praised the 60/40 model of investing where investors are advised to invest 60% of their money into stocks and the remaining 40% into bonds. That exact split may be deemed to be too conservative as a young investor with a lifetime of full-time work ahead of them and the financial wisdom comes from a time when bonds returned handsome yields – but this does of course depend on your personal risk appetite. The reason bonds are supposed to be such an attractive investment opportunity in the face of falling stock markets is because investors tend to park their funds into bonds during an equities downturn and so you would ordinarily experience an upwards adjustment in bond prices.
This has not been realised in 2022 – and for good reason. We’ve spoken many times about the inverse relationship between a bond’s price and its yield (i.e. as the yield rises, the price falls and vice versa). Existing bond funds are currently seen as unattractive because they have already baked in lower yields from years ago and interest rates are on the rise. New investors coming into those bond funds would therefore expect to see a discount in the bond fund’s price to compensate them for the lost higher return they would have received had they simply purchased a new bond at today’s higher interest rates. If you would like to see evidence of this playing out today, google “VBND: ASX”, a Vanguard bond fund which has been falling (in price) since the US 10 year bond yield starting rising.
Ah yes – the only asset class you’re interested in (if you’re an Aussie millennial). Just as borrowing costs are going up for companies, borrowing costs are similarly going up for property borrowers (home owners and investors alike). As central banks like the Federal Reserve and the RBA hike interest rates, mortgage rates will follow. Variable mortgage rates will follow first and existing fixed interest rate mortgages will eventually expire and will need to be refinanced at more expensive rates (probably) later down the track. No one is immune.
Theoretically this should put downward pressure on property prices. Property prices globally have started to fall slightly and it’s important to realise that property is not a forward-looking asset like stocks are. Stocks price-in the future. Property is much slower. There are high transaction costs like legal fees and stamp duty and long transfer times like settlement periods. We should therefore theoretically expect a more meanginful downwards adjustment in property valuations in the future. The reason theoretically is italicised is because it’s proven to be quite dangerous to bet against property markets in the past, especially east-coast Australian property markets. Separately governments have shown a tendency to step in with some creative new tax policy to incentivise investment in the sector and stablise prices. I would therefore argue that property markets tend to be less rational than stock markets and bond markets. Keep in mind also that even if an Aussie millennial’s dreams are realised and a meaningful property decline does eventuate, this will likely follow exorbitant (relative to today) interest rate hikes – which will dampen your borrowing capacity. Something something lord giveth, something something lord taketh.