Interest rates are going up across the world and it will impact all asset classes. While we are currently seeing stock markets reacting negatively, higher rates are going to flow through to the real economy and impact everyone from businesses to consumers, as well as asset values for bonds and property. This isn’t simply market movement that comes and goes. We are witnessing the end of a 15-year period of historically low interest rates, never seen before and unlikely to be seen again. With that comes an entire generation of investors, advisers and fund managers who have not experienced a rising inflation and rising interest rate environment and certainly not a high inflation, high interest rate environment.
Looking back over the long term, the RBA reduced rates over the last 15 years from 5% to virtually 0%. But in the 15 years prior to that (1992-2007) rates were consistently between 5%-7%. Go further back to the 70’s and 80’s and the RBA rate ranged between 6% and 17% for the entire period. Since the GFC, the absence of inflation allowed rates to continue at ridiculously low levels. That changes if inflation starts to dig in for the long term. If inflation gets away from governments, interest rate rises become the primary weapon to fight it and rates will rise to whatever level is needed to curb it. From such a low base a return to ‘normal’ rates in historical terms would be a major problem. I don’t expect that but the move to higher interest rates is a permanent change.
While stocks have fallen significantly over the last month or so there is probably still further to fall before markets settle. But the asset bubbles that emerged globally over the last several years are not limited to stock markets, they include property and bonds too. My view is that the value of fixed rate bonds and property will fall significantly over the next couple of years as interest rates increase. A fall in the price of property seems fairly straight forward. Higher interest rates are going to put pressure on property owners. Banks started lifting their rates last year and tightening their lending criteria.
Residential property is especially vulnerable to a serious downturn. Sky high prices and many property owners are already overextended even with record low interest rates. Borrowers tend to ask the bank ‘how much can we borrow?’ as the starting point for their property purchase and upsell themselves from there as they progress through the process. I expect that residential property will see a similar re-rating to that of the share market, and I wouldn’t be surprised by a fall of 10%-20% or more over the next year or 2. This has significant implications for the entire economy.
I am also cautious of REITs and property trusts across the board, but especially those that use high leverage to generate higher yields. These all look great on the spread sheets and in the prospectus forecasts but that great yield starts to look quite different in an environment that combines soft rents and rising interest rates. Factor in structural issues such as working from home for office property and online shopping for retail centres and it’s going to be more important than ever to be selective with your exposure to REITs and property.
Fixed interest bond values will be under pressure too. In simple terms, if you bought a 10-year bond for $100 last year and it pays 2% pa no one is going to want to buy it from you at that price if the new bonds issued in a year at $100 are paying 4% pa. So, investors are going to be stuck with either 10 years of much lower income if held until maturity or a significantly lower value on the bond if they sell. I prefer bonds and notes with a floating interest rate so that as rates increase so do the rates on the security. This provides investors with an inflation hedge and a welcome pay rise as rates increase.
Be careful with unlisted investments. Investors are often attracted to these investments because their values are more stable. This is one of the dumbest investment misconceptions I have ever heard, and it’s perpetuated by those with a vested interest in the assets. Asset managers from small asset managers to the large industry funds like unlisted assets as they appear more stable. But the reality is that it’s just not valued every day the same way assets listed on the share market are. If interest rates rise and asset prices fall then those unlisted assets won’t be worth as much if you sell them. It’s as simple as that. There is a lag time here to be mindful of.
As interest rates rise, share markets will continue to be volatile. But share market investors do expect volatility and do expect markets to fall from time to time and occasionally crash. It has happened repeatedly over the decades. It is not abnormal. Markets run too far in the good times and then retreat, usually too far, in the down times. It presents opportunities and I look forward to buying at more reasonable levels.
What I am more concerned with right now are the other asset classes where bubbles have evolved and will also come to an end as rates now rise. Property, bonds, and unlisted markets and their investors are far more complacent than the share market in this regard because these markets do not usually experience the level of volatility that is ahead. It means there is likely to be systemic risks within those markets that have developed over many years. The fallout from rising interest rates may well be more harshly felt than many investors and stakeholders in these areas expect going forward.
General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.