Tuesday, 09 July 2013 - 20:00

 

Charts

Interest Rates and the Impact on Asset Prices

Investopedia explains interest as that charged by lenders as compensation for the loss of the asset's use. In the case of lending money, the lender could have invested the funds instead of lending them out.

Interest rates are also used as the core component to discount future cash flows in order to determine their present value. This is essentially taking the time value of money into account with the concept that money available today is worth more than money available at a later date because it can earn interest and the risk of the future cash flows.

An example of discounting future cash flows at different interest rates:

An investment asset that produces future cash flow of R1 000 a year for 10 years and then has a value after the 10 year period of R15 000 (i.e. a total expected cash flow of R25 000), will have a present value of R17 000, should we discount the future cash flows using an interest rate of 5%.

Now using the same cash flows, but rather discounting at a higher interest rate of 8.5%, the value of the same investment asset reduces to R13 200. The upward move in the interest rates negatively impacted the present value of the investment by 28%.

It makes intuitive sense then that at lower interest rates, and all else being equal, income generating assets are worth more than at higher rates of interest. This, very simply, is the major reason that central banks around the world have continued to suppress interest rates over the last 4 years.

Ever since the 2008 global financial crisis which began in September 2008, the US Federal Reserve has been increasingly aggressive about providing financial markets with easy money. So called QE1, started in November 2008, QE2 in Nov 2010, and QE3 in September 2012, where the US is creating an annual $1 trillion in new money in order to purchase US treasury bonds and mortgage backed securities.

In the last Federal Reserve meeting, while the official statement mentioned no real change in current monetary policy, the Fed chairman Ben Bernanke told reporters that asset purchases by the Federal Reserve may begin to wind down. The mentioned timeline of reduced purchases in 2013 and into 2014 spooked the market.

There is some opinion that while the central bank may slow down on newly printed money, it is still likely to hold the benchmark federal fund rate at between 0% and 0.25% per annum for a lot longer and so continue to try and hold down at least shorter term interest rates.

The mere hint at a central bank slowdown saw an immediate spike up in the US 10 year Treasury yield from below 1.7% to 2.15% and now at 2.5% as per the chart below.

The long term chart below gives a clear indication of the tailwinds that asset prices have enjoyed over multi decades as the cost of money and hence the discount rate applied to asset valuations has declined.

The magnitude and direction of interest rates affects both the US local market and global markets in a number of interrelated ways. For example:

The average rate for a 30-year fixed-rate mortgage rose to 4.6% at the end of June, compared to the record low average of 3.4% in December 2012. The low rates have benefitted the recent upswing in property purchases, but this more recent rise will be a slight dampener.

As US interest rates rose, so investors withdrew from the local bond market with foreign investors disinvesting R 6 bn over the last 2 months.

Foreign withdrawals negatively affected various currencies especially in emerging markets. The rand declined from R9/USD at the beginning of May to its current level above R10/USD.

The local JSE All Share index fell from 42 000 to 38 000 mid June.

Local listed property shares slumped just on 20% from mid-May to mid-June

Because of the importance of interest rates on the valuations of all asset prices, it is of critical importance to try and have an understanding of both the direction and the magnitude of interest rates into the future. The longer term picture indicates that we should still be in a downward trend, but shorter term rates have moved up sharply with a negative impact on valuations. It is often, however, at these times of sell-off that investors should take advantage of buying in at cheaper prices.

Kind regards,

Ian de Lange

www.seedinvestments.co.za
info@seedinvestments.co.za
021 914 4966

Tue, 09 Jul 2013

Top News

Index Summary

Stock Exchange News Service

© 2013 Sharenet (Pty) Ltd
Box 30584, Tokai, Cape Town, South Africa
Tel +27 21 700 4800

**Top 5 listings shown.

The Sharenet Daily is provided free of charge by Sharenet
to clients who have registered on our site and elected to receive it.

To update your email address please goto www.sharenet.co.za/snet/der
If you have problems taking yourself off this list please forward a full copy of this email to support@sharenet.co.za

RM~LINK Click here if you wish to unsubscribe from The Sharenet Daily...