Central banks have pushed through 355 interest rate increases in 2022 and made only 15 cuts, according to the website cbrates.com. Global stock and bond markets have fallen and investors are calling for central bankers to reverse course and start cutting the cost of money in 2023.
This is because the direction of interest rates is decisive for how investors allocate their capital between different assets. The return available on cash, and by extension the “risk-free” interest rate available on government bonds, sets the benchmark for assessing the attractiveness or otherwise of all asset types.
The risk-free price
For much of the past decade, bullish investors have argued that stock prices should rise because record low interest rates and government bond yields mean “there is no alternative”. To get any sort of return on their money, they had to look to other, riskier assets.
The test now is whether higher yields on cash and government bonds make them take less risk and charge lower prices for riskier assets, because they feel they don’t need them quite as badly. Savers also need to factor in inflation: it’s ‘real’ returns after inflation that matter.
The yield offered by a government-issued bond is usually seen as the risk-free rate for investors in that country, because the government concerned will not, in principle, default on its obligations. It will always be able to pay the interest on time and return the original investment when the bond matures, even if it has to print money to do so.
The last time Britain defaulted was in 1672, during the “Stop of Exchequer” during the reign of King Charles II, and the 10-year gilt yield is usually seen as the risk-free rate for British investors. At the time of writing, the 10-year-old gilt gives 3.6 pieces. This is the minimum nominal annual return on any investment that any investor should accept.
Risk and return
All other investments have more risk, so the investor should demand more from them.
Investment-grade corporate bonds should yield more than government bonds, because companies can go bankrupt and management teams can do stupid things. High-yield (or “junk”) corporate bonds should yield more than investment-grade bonds, because the companies that issue them are more heavily indebted and the risk of bankruptcy and default is higher.
Stocks should offer the prospect of a higher total return than junk debt, because share prices go down as well as up, while a junk bond will offer predetermined interest payments and a return on the original investment if all goes well.
The return required by investors to compensate for (additional) risk will therefore, in theory, move in relation to the gilt return, which in turn will be influenced by the central banks’ official interest rates.
The price must be right
For stocks, this may mean paying a lower valuation, or multiple of earnings and cash flow, and perhaps demanding a higher dividend yield (achieved by buying at a lower share price).
Remember that the total return from a stock is determined by capital return plus dividend yield, and capital return will roughly be a function of earnings growth and the multiple of earnings you pay for that earnings growth.
In its simplest form, this can be seen in the price-to-earnings (p/e) ratio. Revenues will go up (or down), depending on the business cycle, the company’s place in the economy and the acumen of the bosses.
The price, or multiple, paid can be affected by many things, including the company’s finances and management skills, as well as the predictability and reliability of operations and financial results.
Interest rates will also have a major impact on the multiple. If interest rates and gilt yields rise, investors may feel less inclined or obligated to take more risk with stocks and other assets when safer alternatives offer better returns, at least on a pre-inflation basis.
As a result, they may decide to pay lower prices and multiples, which is why stock markets can fall when prices rise.
Russ Mold is investment director at AJ Bell, the stockbroker
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