Investment Insight |
Keeping it REAL
The influence of real interest rates on technology shares
This is the second in a series of articles that looks under the hood at what is driving markets and how the patterns that we have seen over recent months and years may be changing.
Everyone knows that interest rates are at record lows around the world. What is not as well understood is that real interest rates (interest rates less inflation) have also collapsed. Indeed, the real interest rate in the United States and in New Zealand is now negative and this has important implications for the valuation of other assets.
We are taught in school textbooks that an interest rate is the cost that a borrower must pay to gain access to money now rather than wait for their savings to build up over time. With low interest rates the cost is minimal.
Putting this another way, low interest rates and especially low real interest rates are very positive for assets which have cashflows well into the future, as the discount required to bring them into today’s dollars is diminished.
This helps to explain the exceptional share price performance experienced by technology companies in recent years. Technology companies may not be generating much in the way of earnings today, but they are growing fast and are expected to generate much larger earnings in the future.
Because of the delayed cashflow, their valuations are very sensitive to changes in interest rates. If we do not need to penalise (discount) these future cashflows, then these companies will be worth significantly more.
The key here is that it is not nominal interest rates that are important but real interest rates.
If we see a pick-up in inflation over the next couple of years this may not be a bad thing for shares and more specifically for technology shares. Higher inflation will put downward pressure on real interest rates. However, if longer-term nominal interest rates rise faster than inflation then real interest rates will also rise. This will be negative for technology stocks.
This could be a perfect storm for traditional balanced funds which hold a mix of shares and interest rate sensitive bonds and especially for those who access this mix of assets through passive index positions.
For the last twenty years these portfolios have been lower risk than a pure share fund, as the allocation to bonds has helped to cushion returns when shares are volatile. However, today the bond component will have a longer average maturity and the shares component will have a higher weight to technology shares – both aspects mean that these funds are much more exposed to rising interest rates which could come as a nasty surprise for investors.
In this environment, as active investment managers, we believe that bold decisions need to be made. At NZ Funds you will see Portfolios with securities and asset allocations that are different from the traditional approach, and you will see the allocations change as we actively position client portfolios for the road ahead rather than the road already travelled.
This is the second in a series of articles that looks under the hood at what is driving markets and how the patterns that we have seen over recent months and years may be changing.
Everyone knows that interest rates are at record lows around the world. What is not as well understood is that real interest rates (interest rates less inflation) have also collapsed. Indeed, the real interest rate in the United States and in New Zealand is now negative and this has important implications for the valuation of other assets.
We are taught in school textbooks that an interest rate is the cost that a borrower must pay to gain access to money now rather than wait for their savings to build up over time. With low interest rates the cost is minimal.
Putting this another way, low interest rates and especially low real interest rates are very positive for assets which have cashflows well into the future, as the discount required to bring them into today’s dollars is diminished.
This helps to explain the exceptional share price performance experienced by technology companies in recent years. Technology companies may not be generating much in the way of earnings today, but they are growing fast and are expected to generate much larger earnings in the future.
Because of the delayed cashflow, their valuations are very sensitive to changes in interest rates. If we do not need to penalise (discount) these future cashflows, then these companies will be worth significantly more.
The key here is that it is not nominal interest rates that are important but real interest rates.
If we see a pick-up in inflation over the next couple of years this may not be a bad thing for shares and more specifically for technology shares. Higher inflation will put downward pressure on real interest rates. However, if longer-term nominal interest rates rise faster than inflation then real interest rates will also rise. This will be negative for technology stocks.
This could be a perfect storm for traditional balanced funds which hold a mix of shares and interest rate sensitive bonds and especially for those who access this mix of assets through passive index positions.
For the last twenty years these portfolios have been lower risk than a pure share fund, as the allocation to bonds has helped to cushion returns when shares are volatile. However, today the bond component will have a longer average maturity and the shares component will have a higher weight to technology shares – both aspects mean that these funds are much more exposed to rising interest rates which could come as a nasty surprise for investors.
In this environment, as active investment managers, we believe that bold decisions need to be made. At NZ Funds you will see Portfolios with securities and asset allocations that are different from the traditional approach, and you will see the allocations change as we actively position client portfolios for the road ahead rather than the road already travelled.
Source: Bloomberg
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
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Mark Brooks is Head of Income for New Zealand Funds Management Limited (NZ Funds) and a member of the NZ Funds KiwiSaver Scheme. Mark's comments are of a general nature, and he is not responsible for any loss that any reader may suffer from following it.
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