The supposed benefit, or consequence, of central banks holding interest rates at ultra-low levels since the GFC, and at levels below normalised GDP, has been soaring prices for risky and real assets.
But investors cannot have it both ways; as the US Federal Reserve reverses its highly accommodative monetary stance, the consequence must also be a reversal of those soaring asset prices.
And make no mistake, this process has already begun; however, this time, it is property investors who seem to be experiencing the effects of falling over the precipice, and equity investors have yet to catch on.
We have been tracking US 10-year Treasuries since they hit 1.36 per cent in 2016. Why? Because that was the lowest rate since Captain Cook crossed the Arctic Circle in 1778. And as economist Herb Stein observed, if something cannot go on forever, it must stop. Recently, US 10-year rates hit 3.2 per cent. More about that in a moment.
For more than two decades, I have carried with me an aphorism, and while I cannot recall to whom it should be attributed, I have never forgotten how useful it inevitably and frequently is. The aphorism is this: “Rising interest rates are not a problem until they are.”
Initially, rising interest rates are sign of a strengthening economy but at some point, they become a noose around growth’s neck, strangling it along with asset values. Sentiment simply, and unpredictably, turns. Investors who were once enthused about the prospects for growth start worrying that the effect of higher rates on asset values will affect asset prices.
That inflection point in sentiment might have just occurred.
In the first two weeks of October, the global sell-off in bonds, and the associated rise in bond rates, leaked into equity markets.
On the back of that stronger US economy, real yields are now rising, too; while US 10-year Treasury rates have risen to a seven-year high of 3.25 per cent, the real yield (adjusted for inflation) is now above 1 per cent for the first time since 2011. As the effects on real yields from an end to accommodative monetary policy begin to be felt, the impact will be meaningful.
As rates rise, particularly real rates, the cost of capital and risk premiums increase across the economy, affecting all asset values and the attractiveness of investments and projects.
The worst effects from higher real rates are reserved for long-duration assets – those ‘growth’ investments with future-dated cash flows. Think about those profitless companies like Xero and Afterpay, whose shares have rallied amid a chase for business and share price momentum.
Afterpay, from its opening price this calendar year of $6.00 a share, rallied to more than $21 by the end of August, as the company signed up hundreds of merchants, hundreds of thousands of customers and rolled its offer out to the US and the UK. But in just the subsequent six weeks, Afterpay has fallen by more than a third.
Afterpay still makes no profit and trades on a market capitalisation of $3.2 billion, which is 44 times 2020 net profit after tax. And that 44 times earnings multiple is only on the basis that NPAT increases by more than 300 per cent that year.
Investors in small-capitalisation stocks, and stocks in loss-making ‘growth’ companies, should approach the markets with a healthy dose of caution. Much more so than in recent years. At Montgomery, we have been making portfolio adjustments over the last nine months. As investments were sold, the cash was not immediately recycled; with everything rallying hard, finding value was almost impossible anyway. Instead, the cash was parked awaiting opportunities in larger companies with stocks displaying much lower beta.
And while the bout of volatility in February was short-lived, it seems the current waves may be more frequent or longer lasting, implying elevated levels of equity risk. As higher levels of risk are priced into risk assets, their prices reset at lower levels, ensuring those blind to valuation receive the lower returns that must be a consequence of investing at high prices.
Rising real rates also have a disproportionately large impact on real assets such as real estate.
In New York, London, Hong Kong, Singapore, Sydney, Melbourne, Toronto and Vancouver, property prices are already in decline. Rising interest rates and slowing global (ex-US) growth is putting paid to any unrealistic or idealistic notions that property prices always go up.
Here in Australia, Victorian apartment construction approvals slumped by 35.4 per cent in August alone and overall activity is down 46.5 per cent on a rolling annual basis as property investors desert the market. Indeed, they have good reason for doing so. CoreLogic states that the proportion of loss-making apartment resales is the highest since 1998 at 14 per cent nationally. But the figure disguises the pain felt in individual capitals. For example, in Brisbane, fully a third of apartment vendors are losing money when they sell. In Perth, that number is 50 per cent and in Darwin it is 70 per cent.
It will be some time before property investors return to the market with enthusiasm. In the meantime, property prices can be expected to keep falling as the marginal seller – this weekend’s vendor – is forced either to reduce leverage or to pay more for their debt as interest rates rise and as they are moved onto more expensive principle-and-interest loans.
Whether it is equities or property, the most important aphorism to remember in investing is perhaps this: the higher the price you pay, the lower your return. Property investors are now experiencing the consequences of chasing high prices without reference to income or value. Equity investors who have behaved the same way will inevitably experience precisely the same thing. It’s only a matter of time.
High asset prices, particularly for long-dated earnings and as real rates creep up, will produce lower returns. The only question will be whether those low returns are accompanied by high or low levels of volatility. Those who ignore the warning signs or who pay no attention to valuation will inevitably encounter what so many Australian property investors are already experiencing.
Roger Montgomery is chairman and chief investment officer of his own investment firm, Montgomery Investment Management.
