Higher rates don’t kill investing…
Interest rates are at levels we have not seen since before the Financial Crisis, tempting people into cash, and away from investing.
So, does investing even make sense anymore?
First, it’s worth reminding ourselves that the laws of capitalism haven’t changed:
Governments must pay higher returns than cash to borrow. Governments need to raise money through debt. It’s what keeps pensions paid and the lights on. If cash rates are at 5%, government bonds have to offer people more than that to tempt them out of the bank – even more so if they want them to lock it up for 10 years.
Companies must pay more than governments to borrow. Companies need to incentivise you to lend to them, rather than to the government … which means paying you more than the government does! If cash is at 5%, and government bonds are at 6% (say)… corporate debt must be higher (otherwise why take the risk?!).
Equities have to offer the chance of being paid more than corporate bonds. Companies also need to generate money for their shareholders (who are taking even more risk than their bondholders). Because if their shareholders could do better leaving their money in the bank … soon there’d be no shareholders. And the decision maker at a company knows that. Any new project requiring a cash investment will be judged against the bank rate. If a new project doesn’t have the potential to beat what the bank’s offering, why do it?
The bottom line is that cash sets the bar. Everything else then needs to jump over it.
Of course, it’s tempting to believe that today’s investment circumstances are unique. “This time it’s different!”.
Inflation is high. Government debt levels have soared. Geopolitical hotspots are flaring up in Ukraine, the Middle East and Taiwan. Add to that the transformational developments in AI and the increasingly savage impact of climate change.
Is it different this time?
Look at the below chart. Between 1993 and 2007, interest rates averaged 5.35%. Government debt levels were rising sharply. Geopolitical hotspots were flaring up in Yugoslavia, the Middle East and Russia. The internet was revolutionising society.
In the face of all that, surely just staying in cash, at 5.25%, was best?
Absolutely not.
Source: 7IM/Factset 8/10/23
That higher cash bar created better jumpers. The FTSE 100 (with dividends reinvested) returned 8.1% annualised over that period.
The world continued to jump over the bar…