Experience in financial markets has taught us that while we cannot predict markets or prices we do know that they frequently move in a way that causes pain for the majority. Even Buffett and Munger observed this when they noted the stock market is designed to transfer money from the impatient to the patient.
And it is also true that bursts of severe volatility follow relatively longer periods of calm.
Therefore, now is a suitable time to question accepted wisdom and examine scenarios that might shake investors out of their slumber. Keep in mind however that none of this changes the fact that over the very long run the surest way to generate real wealth – that which preserves and grows purchasing power – is the ownership of businesses able to increase in intrinsic value at an attractive rate.
The US dollar is strong, commodity prices are weak and global bonds are offering negative interest rates in many jurisdictions. This scenario reflects the broadly accepted view that inflation is not a risk and global economic growth will remain challenged. Global financial markets are, then, least prepared for a bounce in commodity prices, a rise in inflation and a fall in the US dollar.
Could any of these scenarios occur and what would be the implications?
The demise of energy?
We have recently observed Moody’s warnings of the record junk bond debt maturing in the next four years as well as the doubling of defaults in 2015. In 2020 alone a total of US$400 billion of junk bond debt will mature – the most in any one year in credit market history. And most of the debt stress currently exists in the energy sector.
According to the Financial Times, 46 companies have already defaulted on $50 billion of debt this year, and half of these were in the energy and mining sector. Weak commodity prices have the largest detrimental impact on the financials of upstream companies, forcing explorers and producers to cut capital expenditure (capex). According to the energy consultancy firm, Wood Mackenzie, around $400 billion worth of energy projects have been scrapped following the crude oil market crash. Separately, Bloomberg quoted new data from the Norwegian consultancy firm Rystad Energy, which predicts that legacy production will tip the supply balance into the negative in 2016 for the first time in years.
Rystad Energy also estimates that the combination of a crash in oil prices and the associated cut in capex, will cause natural depletion rates to overwhelm the paltry new sources of supply in 2016. And this doesn’t take into consideration rising oil demand.
If oil prices were to rise, this combined with higher minimum wages in the US (with more promised by Hillary Clinton), could easily push inflation expectations, if not inflation itself, above the targets set by central banks. And given the fact that lower oil prices haven’t produced any perceptible increase in consumption one can only imagine the recessionary fears that might emerge if energy prices start rising again.
One can also only imagine the carnage on equity and bond markets – from zero and negative interest rates – if inflation emerged and expectations for economic growth declined further.
Interest rates and assets
The purpose of this column however is not to forecast markets nor inspire fear or foolish investor behaviour. Today’s article is merely penned to suggest an indicator to watch closely. It’s the impact on interest rates from the above hypothetical scenario that investors might have reason to be concerned about. They are, after all, the single most important determinant of the returns you will generate for your clients.
Many investors appreciate the inverse relationship between interest rate on a bond and the bond’s price. When a bond is issued, it is done with a coupon payment that is fixed until maturity. A $100,000 bond with a two per cent coupon will make two six-monthly payments that amount to $20,000. If, after the issue of the bond, interest rates rise, then any subsequent investor who buys this bond in the secondary market, will want the $20,000 to represent a higher rate of return than two per cent. To achieve this, they must pay a lower price. And so, when interest rates rise, the price and value of the bond falls.
While this relationship in the market for bonds is well known, it comes as surprising to many that an identical relationship exists between interest rates and all assets. That is, if interest rates rise, their underlying value declines. It matters not whether the asset is a business, a stock, land or any other income producing asset, when interest rates go up, the value goes down.
We know that a million dollars today is worth a great deal more to you than a million in a decade’s time, and so, to value an asset that produces a stream of $1 million cash flows annually we have to discount those cash flows to arrive at a present value. For example, adopting a 2 per cent interest rate as our discount rate, we find that $1 million in ten years’ time is worth $820,000 today.
But if the interest rate we require is higher, say 10 per cent, that $1 million in ten years’ time is worth just $385,543 today. The present value of the future cash flow has collapsed as the interest rate adopted increased.
Why do we care?
Why do we care so much about interest rates and their gravitational effect on assets? Why care about interest rates and present or intrinsic values? Because, in the long run, market prices follow changes in intrinsic values. In the short run, prices might follow China’s slowing economy or Brexit or whether Donald Trump wins the US Presidential elections, but all that will matter in the long run is the change in intrinsic values.
And interest rates will matter more than almost anything else. So keep an eye on the price of oil!
