As Chief Investment Officer at P1 I’m increasingly asked the same question, and I’m sure many of you will have been asked a similar question by your clients; why, when savings accounts are paying ~4% should I risk it and invest?
I’m going to dive in and answer this question and hopefully in a way you can discuss it with your clients too.
The “Risk Free” Rate of Return
Global monetary policy has shifted dramatically since the start of 2022. Interest rates have risen very rapidly from historically lows to level not seen for 15 years. Although Central Banks primary objective from higher rates is to fight inflation, there have been significant consequences for capital markets and asset prices.
All assets trade at prices relative to the anticipated return offered by other assets. The underlying return (and reference point) for investors is the prevailing interest rate on cash, as well as yields on government bonds, depending on the investment horizon. As bank deposits and government bonds are deemed be most unlikely to lose capital, this is considered the “risk free” rate of return. Although government bond yields do not depend only on interest rates, they are strongly linked.
This means that the change to Central Banks’ interest rates through to the “risk free” rate, including government bond yields, has had a significant effect on other assets in investment portfolios. In the secondary markets, prices reflect movements in interest rates and expectations. For example, the rises in interest rates have been mirrored by a rise in UK government bond yields. This has caused a typical 10-year bond yield to increase from 0% to over 4%.
As a rule of thumb, every 1% change in yield, moves the bond price by 1% for each year of duration. For the 10-year bond, the price fall was some 30-40%.
While this effect is easiest to see on a government bond, the repricing will impact all assets over time. Generally, the more liquid and more easily valued an asset is, the faster a repricing may occur.
The impact of duration, risk premium and inflation also influences the price. Consequently, assets with some inflation protection, such as equities or infrastructure, have fared better through this period of change. When rates were low, holdings in non-yielding or growth assets meant that little or no interest was forgone. But now, with higher cash rates, the interest given up becomes tangible, making investments in these less attractive. As the interest rate has increased, the expected return across all asset classes needs to be rebased. All asset valuations, including property, equities, and infrastructure, are now expected to deliver a higher rate of return than they did two years ago. If assets’ yields have not increased in step, an increase in expected return can only be achieved by falls in capital values.
Unfortunately, this has generally lead to some capital losses in the short term but does mean that the prospect for higher returns going forward is now significantly improved.
This is an important consideration for comparing investment portfolios’ historic performances as we have moved to current higher cash returns. Contrasting the recent historical returns against current cash rates is not like for like. The historical investment backdrop over the last 5-10 years was fundamentally different with interest rates close to 0% and very low inflation. For example, one would not compare historical cash returns over the last few years with current interest rates and feel this meaningful. Lower returns over the historical period were not unrealistic. Conversely, now that expectations are for higher interest rates, in a higher inflation environment, looking forwards, we would expect higher nominal returns from portfolios.
This does not mean that there will not be periods of weakness. Sentiment changes and market shocks can still occur. The market shift that has been experienced over the last two years will influence returns over the long term, meaning 5 years, if not the next decade and beyond.
Take Away Points for Your Clients:
- Contrasting historical returns against current cash rates is not like for like
- Change in interest rates means all assets are being revalued
- Expected returns from investment portfolios are significantly higher, reflecting higher interest rates.
- The winners in the low interest rate, low inflation environment may not be the same in the current higher interest rate, higher inflation environment
- An assessment of inflation and real expected returns should be considered alongside the nominal rate
- As always, long term horizons are required when evaluating asset class returns.