Jeremy Siegel, Ph.D. The Future for Investors
Profit From Higher Long-Term Rates
by Jeremy Siegel, Ph.D.
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Posted on Friday, June 29, 2007, 12:00AM
Since the middle of March, the world’s bond markets have witnessed a sharp increase in long-term interest rates.
The ten-year U.S. treasury bond has risen from 4.50% to 5.15% and reached as high as 5.30% on June 12. Rates in Europe have increased even more than the U.S., as the ten-year German bond has risen from 3.90% to 4.70% and the U.K. bond from 4.75% to 5.55%.
Even in Japan, home of the world’s lowest interest rates, the Japanese government bond rose from 1.50% to almost 2%. These long-term rates directly impact not only the cost of corporate capital, but also the mortgage market, where rates have risen to nearly 7% for some 30-year mortgages in the U.S.
The primary source of these rising rates is not the tightening by central banks, but the brightening economic outlook for world growth. Higher growth raises rates since businesses and governments need capital to expand plant, equipment, and infrastructure.
The Pricing of Financial Assets
What does this mean for investment strategy? To understand what this means we should turn to some basic asset pricing theory. Finance posits that the price of any asset is the present discounted value of the cash flows that come from that asset. For stocks, the cash flows are dividends. For bonds, they are interest income. And for real estate, they are rental income.
Future cash flows are not just added together, but are “discounted,” since a dollar received in the future is not worth as much to investors as a dollar received today. The discount rate reduces the value of these future cash flows.
The discount rate is dependent on two factors: the rate of interest on safe bonds (such as U.S. government bonds) plus a “risk premium” to compensate for the possibility that the future cash flows will not be paid as expected. The interest rate in turn is composed of two parts: one part to compensate bondholders for inflation, and the other, called the real rate, which is linked to productivity and growth.
What we have seen over the past three months is an increase in the real rate of interest, not an increase in the inflation premium. We know this because the U.S. government issues special treasury inflation-protected securities (called TIPS bonds) that automatically compensate the owner for inflation so that the rate carried on these bonds is the real rate.
Since mid March the interest rate on the TIPS bond have risen from 2.10% to 2.70%, meaning that almost all the increase in the U.S. bond rate is due to this real rate increase.
Impact on Stocks, Bonds and Real Estate
With this understanding we can judge how an increase in economic growth influences the bond, stock, and real estate markets. The bond market, of course, suffers the most from the increase in rates since the cash flows of bonds, namely the coupon payments, are fixed in contractual terms and do not respond to the stronger economic outlook. Indeed, since mid-March, government bonds have fallen 4% or more in price.
However, the impact of increased economic growth on stock prices is ambiguous. Certainly higher growth means higher profits and therefore higher cash flows. But the rise in interest rates also increases the rate at which these higher cash flows are discounted, which has a negative impact on the price. Stocks have in fact been volatile with no clear direction since rates have risen.
Real estate falls between stocks and bonds. The rise in interest rates increases the cap rate, which is the name given to the rate at which future rental income is discounted and this lowers real estate prices. But a stronger economy allows for higher rents, particularly for commercial and industrial real estate, which partially offsets the rise in the cap rate.
For most real estate it is unlikely that the rise in future rents will completely offset the increase in the interest, so I expect the price of most real estate to continue to fall. This is particularly true of residential real estate in which the feedback from a stronger economy to higher rental rates is quite weak.
Finally we should talk about the risk premium, a component of the discount rate for real estate and especially stocks.
Stronger growth usually lowers risk premiums since higher profits mean better interest coverage on borrowed funds. But higher interest rates can be very burdensome for firms that are highly leveraged, such as real estate. That is why we are seeing the prospects for this sector continue to dim. If a real estate slowdown spills over into the rest of the economy, risk premiums could go up everywhere, driving down stock and risky bond prices.
Where’s the Market Headed Now?
I believe the real estate slowdown will not significantly damage the rest of our economy. The upward revision in growth has already brought about adjustments in the capital markets. These adjustments will actually help the Fed control the inflationary pressures and make it less likely, in my judgment, that it will raise rates in the future.
In this environment I think equities will hold up the best, with real estate lagging, and bonds, especially those issued by highly leveraged firms, faring worst. Higher rates only make one class of investor very happy – those that are in cash. But these investors should realize that cash has a very poor long-term return. If you have been lucky enough to have stayed liquid recently, think of deploying some cash to a world-wide portfolio of stocks now. In the long run you will not be sorry.