Interest rates are to asset prices what gravity is to matter – Warren Buffett
Why haven’t house prices collapsed? This was the inviting title of a recent FT article. It began by suggesting that there is normally a correlation between economic activity and house prices, before reporting that, as is so often the case in economics, fact has failed to follow theory. Thus, in 2020, while the UK economy shrank by 9.9%, house prices rose by 8.5%. Adding insult to injury, the article points out that the theory hasn’t just failed in the UK. Last year, across the 37 advanced economies in the OECD, house prices increased at the fastest pace since 1990 while in Sweden house prices have risen by 18.9% in the past 12 months – the most rapid pace of increase on record. At this point, of course, explanations pointing to stamp duty holidays, the shortage of building land in the UK and even the impact of the furlough schemes ring hollow – clearly, something else is going on.
In our view, that something else is the price of money: the interest rate – by far the most important price, or rather set of prices, in any economy. At its simplest, an interest rate is the price for having today what you can’t pay for until tomorrow, or later. This price has, of course, tumbled in recent times. In the UK the official interest rate set by the Bank of England was an already low 0.75% prior to the pandemic, by April 2020 it was 0.1%. This is, by a long, long way, the lowest interest rate since the proverbial records began, and almost certainly, ever. The US central bank, the Federal Reserve sets a range in which it aims to keep interest rates. This was 1.5%-1.75% at the beginning of 2020, by mid-March the range was 0-0.25%.
For context, in 1980, US interest rates peaked at 20%. A period of forty-one years has seen interest rates fall to one-hundredth of that level. In the UK, the numbers are comparable, as 1980 dawned UK rates had recently been reduced to 16%. For us, there is no doubt that low interest rates are the key explanatory factor not just for house prices, but all asset prices – including equities. As the above quote from one of the all-time great investors suggests, a useful parallel for the impact of interest rates on asset prices might be to consider low rates as equivalent to reducing gravity. If the force of gravity were reduced by 99 per cent, how high might an athlete be able to jump? No doubt a physics student could give us a more precise answer. ‘Higher, perhaps quite a lot higher’ is sufficient for us.
At this point, we would like to briefly turn aside to address something that we regard as a popular myth, and at the same time cover off a topic that frustrates us every time we read about it. Together, these two take us to a place where we can explain house prices and where we can think about asset prices without preconceptions about interest rates.
The popular myth is that central banks have absolute control of interest rates. They don’t. What they can do, thanks to the size of the government within the economy, is bully very short-term interest rates via the central banks’ control over currency issuance and the liquidity position of the clearing banks. This, in our view, is not very much. To support this point, we might recall the UK’s exit from Europe’s Exchange Rate Mechanism (ERM) in 1992 during which interest rates were increased by 5% in a single day, before the UK Treasury (which was responsible for setting rates at the time) was forced to admit that it could not force water to flow up hill. By the end of that historic day, interest rates were back to where they had started and sterling was out of the ERM. This is a high-profile example to demonstrate a point. But it doesn’t require too great an exercise of thought to see that most of the time central banks are following market rates – those used by companies, individuals and institutions to lend to each other – not leading them. If, for example, instead of reducing interest rates in March 2020, central banks had set them at 5%, they wouldn’t have forced market interest rates up to this level. Instead, market rates, would, in the face of the major economic disruption that the virus presented, have fallen sharply regardless. Similarly, if in 1981, Paul Volcker, Chairman of the Federal Reserve, had decided that, instead of attempting to tame inflation with very high interest rates, a rate of, say, 5% was more appealing, market rates would not have fallen to this level. Instead they would have risen sharply, as lenders fearing ever higher inflation demanded higher rates of interest or baulked at lending at all.
This brings us to our pet frustration. This is, in short, the tendency of journalists and other commentators to refer to interest rates getting back to ‘normal’ – usually something around 5%. This nostalgia for the good old days in financial markets is nonsense. If the interest rate is simply a price, waiting for it to get back to some historic level makes no more sense than waiting for average salaries to get back to £10,000 per annum – or the price of a three-bed house in Clapham to go back to £15,000.
In our view, these two observations are crucial both to the equity market valuation debate and long- term asset allocation decisions. If we can shake off the misconception that central banks are somehow forcing interest rates to artificially low levels – from which they must at some point rise back to some ‘normal’ – we are then free to consider what the right price is today for a stream of future cashflows. This is the case whether we are thinking about Swedish house prices, house prices more widely or equities. This is not to say that we don’t think interest rates will ever rise. It is simply that the presumption that they are, with certainty, far too low and must revert to some historically observed level is unhelpful and probably wrong. Such a view would certainly have led us to some poor investment decisions over the past 30 or so years. If we can entertain the possibility that the decline in interest rates is not a temporary aberration but a market derived price, we have a convincing answer as to why house prices haven’t crashed – and, more importantly why equity markets are where they are.
In forming a view as to where equities go from here, we need to consider the future earnings power of those equities, as well as the direction and level of interest rates. If pushed to answer whether the full impact of very low interest rates is reflected in equity prices, our first answer would be, ‘no’. However, we would qualify this by highlighting that there are many moving parts to this calculation. These include the likely growth and resilience of the earnings stream we are valuing to wider considerations such as the impact of asset price inflation on inequality and the political and taxation consequences thereof.
