Stay abreast of COVID-19 information and developments here
Provided by the South African National Department of Health
Your investments and
the changing price of money
With inflation at multi-decade highs in most developed countries, central banks have now entered a rate hiking cycle. This has lifted the price of money, as well as the hurdle for the prospective returns of other asset classes. While we believe these changes have been priced in reasonably effectively by financial markets, there are risks that remain. What does this all mean for investors – how do we position multi-asset portfolios appropriately in the current environment?
After the world emerged from the global financial crisis in 2008 and 2009, short-term interest rates – in effect, the price of money – were kept low in a bid by central bankers to boost the global economy, and as evidenced by sustained growth over the following decade until 2019, this approach was largely successful.
Since the start of 2022, however, the price of money has changed. After years of cheap money, interest rates are rising globally, and since this is the most important determinant of asset prices, it has implications for all asset classes.
It all started in the US – since the funds rate of the US Federal Reserve (the Fed) is the baseline off which the rest of the world determines the price of money in various currencies. For readers not well versed in economics, this is due to the position of the US dollar as the world’s reserve currency as part of the 1944 Bretton Woods agreement.
It’s also as a result of perceived security associated with US government debt. The geographic positioning, economic might and military superiority of the US mean it’s the country least likely to be successfully invaded. So short-dated US treasuries carry the lowest default risk. Like it or not, the US sets the tone for global monetary policy.
For 79% of the time since January 2009, the Fed funds rate has been below 1%, and 93% of the time it’s been below 2%. Although the rate is currently still under 2%, we expect this to change in the coming weeks and the futures market is pricing in a rate of 3.5% by the end of 2022.
A key tenet of finance is that the present value of a stream of future cash flows must be viewed relative to the other available options. The Fed funds rate is the foundation for such relative assessment.
For example, from 1980 to 1982, if you lent money to the US government by buying 30-day US treasuries, you would have received around 15% interest per year, risk-free. So, to be enticed to buy any other – by definition, riskier – asset, an investor would expect a higher return to be compensated for the additional risk.
If you wanted to borrow money to open a factory, for instance, you would have had to offer the lenders an interest rate above 15% to induce them to lend the money to you rather than the US government. For it to be worthwhile for entrepreneurs to build factories in 1981, the expected return needed to be quite high, likely over 20%. This meant that relatively fewer factories were put up at that time.
While money was exceptionally expensive over that period, the price of money then entered a multi-decade secular decline, where it became progressively cheaper through lower interest rates. This was, of course, fantastic for economic growth.
During the period from 2009 to 2017 and again through 2020 and 2021, the risk-free rate was below 1% – beating this rate was far less expensive for potential borrowers. Accordingly, many new potential projects became economically feasible, with large corporates often able to obtain long-term debt funding at 3% interest. If you can borrow money at 3%, then a project with an expected 6% return is attractive and likely to be approved.
On a larger scale, stock markets function the same way by offering potential investors the chance to invest their money into enterprises that expect to make profits. When investors’ risk-free alternative is offering low returns, the stock market appears relatively more attractive. This results in prices being bid up, driving expected subsequent returns down. This was essentially the situation from 2009 to 2021, with the exception of the Covid-19 period.
From 1970 until 2008, the Fed funds rate was mostly above inflation, so money had a cost in real terms. Since that time, short-term interest rates have generally been below inflation, so those buying ‘risk-free’ assets were losing money in real terms. This created a ‘there is no alternative’ narrative, driving investors to seek positive real returns through riskier assets, mostly via corporate bonds and equities.
With so much cheap money floating around, inflation was inevitable, but the party continued for far longer than economists expected. Eventually, pandemic-related supply shocks tipped the scales in favour of inflation. With inflation at multi-decade highs in most developed countries, central banks have now entered a rate hiking cycle, which has lifted the price of money.
The hurdle that the prospective returns of all other assets need to clear has risen, and higher future returns require lower current prices. For the average person, higher interest rates mean that debt – such as home and car loans – becomes more expensive. In 2021, someone who bought a US$500 000 house was paying US$2 100 per month at 30-year mortgage rates of 3%. Now repayments on such a loan are US$3 000 per month.
Looked at from another angle, that US$2 100 monthly repayment will now buy you a US$350 000 house, with rates at 6%. So (unrealistically) keeping everything else equal, US house prices would need to decline by 30%!
In real life, US house prices won’t fall by that much since most homes are at least partially paid off, many homeowners have fixed rates, people are typically not willing to sell for materially less than they paid, and people will look to cut back on other spending to be able to afford mortgage repayments.
The concept is the same for stocks, although the quantum of the change is not quite as brutal as the house price illustration. Most larger asset managers have long understood that rates were artificially low. So the first part of the increase in the price of money from 0% to 1% was essentially ‘free’, as it was already baked into prices.
The second important concept is that higher rates are driven by increased inflation expectations, which would be priced into long-term expected growth rates. Without boring readers with the maths, the jump in the Fed funds rate from 1% to 3%, coupled with an increase in long-term inflation expectations from 2% to 2.5%, should result in a roughly 23% decline in the value of stocks – or a decline in the justifiable price-earnings multiple from 20 times to 15.4 times.
The MSCI World Index is down 21% so far this year at the time of writing, which suggests that the change in the price of money has been priced in reasonably effectively by markets. The remaining risks are two-fold:
Through the cheap money era, there was little opportunity cost of speculating in unproductive assets. Assets that don’t generate income, from cryptocurrencies to cars and art, did well since you didn’t miss out on much by not holding them. This has changed, as is most clearly evident in the more than 50% decline in the price of bitcoin so far in 2022.
At Sanlam Private Wealth, we’ve long recognised that developed market interest rates have been artificially low, which is why our holdings of developed market bonds in our multi-asset portfolios have been much lower than what we would consider a ‘normal’ level.
This has also come through in our stock-picking, where our valuation-driven approach has helped us avoid most of 2021’s overpriced market darlings, resulting in the market declines of 2022 both in South Africa and globally impacting our clients to a lesser extent. This serves as a reminder that the road to market-beating returns is not just about finding winners in the good times, but also about avoiding loss in more difficult times.
The road ahead for the global economy, as well as for stock prices, is far from certain and likely to be rocky. At Sanlam Private Wealth, we remain committed, as always, to our tried-and-tested philosophy and approach, and our long-term investment horizon.
Sanlam Private Wealth manages a comprehensive range of multi-asset (balanced) and equity portfolios across different risk categories.
Our team of world-class professionals can design a personalised offshore investment strategy to help diversify your portfolio.
Our customised Shariah portfolios combine our investment expertise with the wisdom of an independent Shariah board comprising senior Ulama.
We collaborate with third-party providers to offer collective investments, private equity, hedge funds and structured products.
We constantly challenge the norm. Our investment process is a thorough and diligent one.
Michael York has spent 18 years in Investment Management.
Have a question for Michael?
About UsWhy Choose Us? Leadership Team
What We OfferInvestment Management Fiduciary and Tax Equity-backed Finance Stockbroking and Derivatives
ResourcesResources Our Views Investments Our Story
South AfricaSouth Africa Home Sanlam Investments Sanlam Private Wealth Glacier by Sanlam Sanlam BlueStar
Rest of AfricaSanlam Namibia Sanlam Mozambique Sanlam Tanzania Sanlam Uganda Sanlam Swaziland Sanlam Kenya Sanlam Zambia Sanlam Private Wealth Mauritius
GlobalGlobal Investment Solutions
Sanlam Private Wealth (Pty) Ltd, registration number 2000/023234/07, is a licensed Financial Services Provider (FSP 37473), a registered Credit Provider (NCRCP1867) and a member of the Johannesburg Stock Exchange (‘SPW’).
All reasonable steps have been taken to ensure that the information on this website is accurate. The information does not constitute financial advice as contemplated in terms of FAIS. Professional financial advice should always be sought before making an investment decision.
Participation in Sanlam Private Wealth Portfolios is a medium to long-term investment. The value of portfolios is subject to fluctuation and past performance is not a guide to future performance. Calculations are based on a lump sum investment with gross income reinvested on the ex-dividend date. The net of fee calculation assumes a 1.15% annual management charge and total trading costs of 1% (both inclusive of VAT) on the actual portfolio turnover. Actual investment performance will differ based on the fees applicable, the actual investment date and the date of reinvestment of income. A schedule of fees and maximum commissions is available upon request.
COLLECTIVE INVESTMENT SCHEMES
The Sanlam Group is a full member of the Association for Savings and Investment SA. Collective investment schemes are generally medium to long-term investments. Past performance is not a guide to future performance, and the value of investments / units / unit trusts may go down as well as up. A schedule of fees and charges and maximum commissions is available on request from the manager, Sanlam Collective Investments (RF) Pty Ltd, a registered and approved manager in collective investment schemes in securities (‘Manager’).
Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. The manager does not provide any guarantee either with respect to the capital or the return of a portfolio. Collective investments are calculated on a net asset value basis, which is the total market value of all assets in a portfolio including any income accruals and less any deductible expenses such as audit fees, brokerage and service fees. Actual investment performance of a portfolio and an investor will differ depending on the initial fees applicable, the actual investment date, date of reinvestment of income and dividend withholding tax. Forward pricing is used.
The performance of portfolios depend on the underlying assets and variable market factors. Performance is based on NAV to NAV calculations with income reinvestments done on the ex-dividend date. Portfolios may invest in other unit trusts which levy their own fees and may result is a higher fee structure for Sanlam Private Wealth’s portfolios.
All portfolio options presented are approved collective investment schemes in terms of Collective Investment Schemes Control Act, No. 45 of 2002. Funds may from time to time invest in foreign countries and may have risks regarding liquidity, the repatriation of funds, political and macroeconomic situations, foreign exchange, tax, settlement, and the availability of information. The manager may close any portfolio to new investors in order to ensure efficient management according to applicable mandates.
The management of portfolios may be outsourced to financial services providers authorised in terms of FAIS.
TREATING CUSTOMERS FAIRLY (TCF)
As a business, Sanlam Private Wealth is committed to the principles of TCF, practicing a specific business philosophy that is based on client-centricity and treating customers fairly. Clients can be confident that TCF is central to what Sanlam Private Wealth does and can be reassured that Sanlam Private Wealth has a holistic wealth management product offering that is tailored to clients’ needs, and service that is of a professional standard.