You can’t escape gravity
In economics, interest rates act a little like gravity.
Any changes in interest rates, anywhere in the world, changes the value of financial assets.
Of course, this is blindingly obvious when you are looking at bond prices shifting, but the rule also applies to all other classes of financial assets, including equities, farmland, commercial and residential real estate or commodities.
Simply put, if interest rates are at 10% then the present value of each dollar you receive on any investment is much lower than when interest rates are at 2.50%.
Interest rates impact financial markets.
Famously, Warren Buffett, who knows a thing or two about investment markets, provided the empirical evidence for this in a speech in 2001.
He noted that in the 17 years between December 1964 and December 1981, the US Gross National Product (GNP) increased by a whopping 373%, yet the Dow Jones index essentially went absolutely nowhere, from 874.12 to 875.00.
A major driver for this was that long-term bond rates ran from 4.20% in 1964 to an eye-watering 13.65% by 1981.
In the next 17 years from December 1981 to December 1998, GNP in the US only increased by less than half as much at 177%, yet the Dow Jones went on a bonanza run from 875 to 9,181.43, a truly staggering increase.
Largely because interest rates altered the landscape for financial assets by falling from 13.65% to 5.09%, and this changed the way people invested their money.
We’re seeing it happen again now, with rock bottom interest rates in the US firing the Dow from below 7,000 to well above 16,000 since the financial crisis.
Given that investors must contend with inflation, and with interest rates at rock bottom, bonds and fixed interest investments have about-faced as an investment choice from offering “risk free return” to practically guaranteeing “return free risk”.
A decade of low rates
You didn’t have to be a genius, then, to work out that very low interest rates across the globe would cause a shift in the way people invest their money.
Below I’ve charted the rates trend in Australia, the US, the United Kingdom, the Eurozone and Japan from 1990 until today (click chart)
The thing about money is that there is an awful lot of it around the world and all of it has to find a home.
Here are the six of the main places people might choose to put their money.
1. Cash/fixed interest
Lending investments range all the way from cash in your bank account, to term deposits, government bonds, inflation-linked bonds, corporate bonds, notes, debentures, or hybrid investments, subordinated debt, and a stack of other stuff.
The basic principle is that the lending of money is exchanged for interest payments.
Clearly with interest rates at historic lows, fixed interest returns are presently very low. High yields are generally only obtained from low grade or perceived riskier investments.
As a result, lending investments are far less popular than they have been and this is seeing a huge shift of global capital towards other asset classes, in particular…
When my first book Get a Financial Grip was published, I put forward the opinion that if financial freedom is your goal, then the best means of achieving it for the average investor in Australla could be:
(1) To get broad exposure to (certain suburbs of) Sydney real estate for the long term,
(2) To continue building a diversified portfolio of dividend-paying equities, and
(3) Keep a very healthy cash buffer.
For long-term investors, assets which bring income and the potential for capital growth tend to beat the cash/fixed interest investments.
Buffett stated that only certain asset classes fulfil these criteria from his perspective: profitable businesses, equities and real estate.
I noted that my suggestions were particularly so given the low interest rate environment (which would likely see funds flowing away from cash and fixed interest and into share markets).
Low interest rates have been very kind to share markets in Australia of late, while investors continue to derive annual benefit from tax-favoured dividends which come with franking credits attached.
3. Real estate
Even last year people were still arguing that Australia’s housing markets aren’t interest rate sensitive.
Remember, though, that all financial assets are in some way sensitive to interest rates.
Questioning of the effectiveness of monetary policy tends to be a part of every economic cycle, of course, but monetary policy generally does work and, like all financial assets, housing markets are ultimately responsive to changes in the cost of capital.
What may have wrong-footed commentators was that there tends to be a lag in effect, with the full impact of interest rate cuts on occasion taking up to 18 months to be seen in full.
A dramatic turnaround in the tenor of online comments from schadenfreude to snarky has been a fairly reliable indicator of the property markets having moved into a new phase.
The chart below shows what has happened since the most recent trough in mid-2012 which includes a very strong rebound in Sydney and Melbourne (click chart).
The most popular for average investors are gold and silver, which don’t pay yield but can represent a hedge with a portion of a portfolio.
It’s been a rollercoaster ride for the precious metals over the last year or two.
Who knows where to next?
Buffett sees gold as a barren asset, since it pays no income or yield.
In 2011, he drew the analogy that the world’s gold stock of 170,000 tons (about 68 square feet) had as great a total valuation at $9.6 trillion or $1,750/oz of all the cropland in the US, plus 16 Exxon Mobils (the world’s most profitable company in 2011, generating net profits of $40 billion annually) and around $1 trillion of walking around money.
When put in those terms, of course, Buffett explains that the choice is a no-brainer, since farmland will continue to produce income and growth over the decades.
The price of gold tends to peak at times of fear and so can represent a worthwhile hedge for some investors with part of their portfolio.
Buffett’s main gripe is that if you hold a bar of gold for 50 years, at the end of the process you still have that same gold bar, and it still pays no income. Thus, he argues you are hoping for more speculators to push up the price in times of fear.
Investing in collectables such as art or antique coins tends to be handy…for experts.
6. Get rich quick schemes
There have been a lot of these over the years, from pyramid schemes to exotic new diamond mines and emu farms.
Get rich quick schemes tend to be very suitable for people who have some money and want to rid themselves of it quickly.
4 rules for investing
Rule 1 – Diversify
Don’t put all your eggs in one basket – you should have your business, property, shares and cash.
It’s easy enough to get diversification in the share markets through using Listed Investment Companies (LICs) or index funds, but one of the problems with real estate is that the leverage involved sees you quickly gain exposure to only a handful of correlated assets in one asset class.
For this reason, while it’s not for everyone, I invest heavily in UK property too.
The beacon of truth that is the Daily Mail reported over the weekend that house prices in Britain had increased by as much as £50,000 to £100,000 in only one month, particularly in London and the south-east.
While I certainly don’t make a habit of believing everything I read in the Daily Mail, as an active participant in the London market, I can tell you that well-located and in demand property may easily have seen a 5-10% price uplift in recent months.
In a separate article, the Mail also reported that a surge of investors using their savings and retirement funds could push UK house prices up by 30%. Why? Because the UK’s zero interest rate policy (ZIRP) has crucified the value of annuities.
Just like gravity, you can’t get away from interest rates.
Rule 2 – Investment is not about luck
Successful investment is not about luck. It is about patience and discipline.
Rule 3 – Markets are cyclical
In every cycle, people argue that this time will be different. But corrections follow booms and markets slump before booming again. Cycles continue.
Investors need to have an awareness of whether asset prices are near their peak or nadir and plan accordingly.
Rule 4 – No free lunches
Very high returns tend to be achieved only through riskier ventures.
If something sounds too good to be true, it probably is.
This is true in bonds where high yields often come with a high risk.
In equities, the opportunity for doubling your money quickly tends to come with an equivalent chance of halving it (or worse).
And high yields in residential real estate are frequently found in areas of lower demand.
When it comes to property, my view has always been while you may certainly start small, you ultimately need to play in a big pond.
Just like Buffett’s point on barren assets – if you invest in a cheap property in a cheap location, then at the end of the process you will still have a cheap property in a cheap location, and the returns adjusted for inflation will likely be lacklustre.
On the flip side, I know of Aussies who invested in London’s Mayfair years ago who have achieved returns that are almost beyond belief – both in terms of capital growth and in terms of income.
See how much a 2 bedroom apartment might let for in W1 today and you’ll get an idea of why property in high demand areas tends to outperform massively over the long term.
That’s why I’ve tended to look for properties with an ‘X factor’ that will be in demand for decades to come, such as properties close to the City of London, or in Australia located in Bondi, or on the Sydney harbourside.
Cheap regional properties can perform reasonably well over short periods of time, but over the long term well-loated capital cit properties outperform.