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Low Is Not Normal

By Roger Montgomery

Low Is Not Normal

Run fast and now!

When the sun is shining, and its sparkle shimming off the water, a view of Sydney Harbour is one of the best in the world.  The grungy cafes and laneways of other cities look like dank, grimey metal-recycling facilities by comparison. The Sydney views are so covetable that prices for Sydney harbour front homes will hit $100 million at some stage in the not too distant future.  Had Sydney Harbour been located any closer to the US or Europe, prices would have hit $100 million many years ago.

Despite its desirability, many residents literally draw their shades on the view - as any cruise around the harbour will reveal.  Residents quickly become used to the world-class view despite its beauty and its price.

Low interest rates are a bit like that.  We get used to them and acclimatise to the environment, operating as if it’s normal.  Financial commentators have labelled this low-return environment the new normal but it’s anything but normal.  And getting used to it is a very dangerous plan and a hazard to your wealth. 

Getting used to it, and even settling-in, has however been exactly what Australian households have done. While household debt in the US, UK and Germany has fallen materially since the GFC - and in the US, debt as a percentage of disposable income has declined from 138% to 108% - the reverse is true in Australia.

Aussie battlers have leveraged-up to chase asset prices higher, particularly property, increasing their debt burden to 185% from 170% of disposable income since 2008.  As a nation, we are ill-prepared for any reversal of the global bond market rally that is now in its third decade.

The inverse relationship between bond prices and yields means that as bond markets decline, long–term interest rates will rise.

The value of any asset is simply the present value of all its future cash flows discounted back to today.  Intuitively, receiving $100 immediately is worth much more than receiving $100 in ten years time.  In order to work out how much more valuable the $100 is today, we need to discount the future $100 back to today to be able to compare them.  If we use a 7% rate to discount the future $100 back to today, we arrive at $50.83.  If interest rates fall and we start using a 3% discount rate, the present value of the future $100 becomes $74.40.

In other words, the value of the asset has risen 50% simply because the discount rate we use to value the asset has declined from 7% to 3%.  Global sovereign ten-year bond rates have been in decline now for 30 years and the declines experienced over the most recent decade are not the result of the normal buying and selling activity by rational and sensible long term investors.

The most recent declines in bond interest rates – particularly the move to negative interest rates for 30% of the world’s sovereign bonds – is the work of central banks.  Their collective activity has produced rates that no longer, even reasonably, reflect risk. 

When Italy can borrow money at negative rates despite non-performing loans in their banking system amounting to 25% of GDP the bond market has ceased properly signalling risk.

And yet these low rates are what professional investors are using to inform the discount rates they use to value assets.  And the greater the proportion of cheap debt a company has, compared to relatively more expensive equity, the lower the discount rate that can be adopted.  Think about that for a minute; a company’s shares are more valuable because it has more debt.

Of course all this will unwind and we will look back with astonishment that investors were, for example, willing to lend money to the Swiss government for thirty years to receive 96% of their capital back.  It is such an environment that prompted Bill Gross to state the $10tn pile of negative-yielding government bonds is a “supernova that will explode one day”.

The question we should then be asking is how long will the party continue before the punchbowl is taken away?  Or perhaps a better question is, should I simply go home early and not hang around to see the stampede for the narrow exit?

Investors in shares, property and other high priced assets can, at best, expect only low returns.  At worst, violent volatility will accompany those low returns.

Low interest rates aren’t normal and they aren’t permanent so don’t get used to them.  Awareness of that fact should have you beginning to behave very carefully.

 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!