Investors today are dealing with strong macro winds. It is not about the war in Ukraine, earthquakes or the divides in politics - those are all areas of concern to be addressed in other forums - it is about the persistent rise in interest rates. A wise and tenured investment manager was asked what his prediction was on rates and his response was that no one can really predict two things, inflation and interest rate direction. Recall the smart minds at the central banks calling “inflation transitory” not too long ago?
When we invest in something, we are really investing in the future cash flows of the underlying asset. In the case of bonds, that future cash flow is fixed at the coupon rate, hence the term fixed income. For common stocks we are buying future dividends that hopefully grow as the business expands. If you are buying something with no cash flows, you are speculating that someone will buy it from you at a higher price in the future. So, for long-term investors in this macro environment of rising interest rates, it is good to get a refresher on the concept of Present Value (PV) and how near-term cash is now more valuable than future promises of big returns.
We have all heard of the saying “time is money”, so intuitively we know the two are connected. PV is the calculation to determine the value today of the sum of future cash flows at a set discount or hurdle rate. This is the basic time value of money that suggests $1,000 today is worth more than $1,000 at some point in the future. In the case of investments, the sum of all future cash flows weighed against the discount rate is the basis for pricing and has a direct impact on the AccountBalance we see! The takeaway here is the higher the discount or hurdle rate, the lower the PV and the lower pricing of our investments.
Inflation is the process in which the prices of goods and services rise over time. As investors, our baseline goal must be to protect the purchasing power of our money. So, the prevailing interest rate is a great hurdle rate for our return goals. If the persistent rate of annual inflation is 5%than we would choose to invest in areas where we can foresee 5%+ annual returns or it would not be worth it. In PV calculations, the picking of the discount or hurdle rate is subjective, but using the risk-free rate of return on a government three-year Canadian bond (~4%) or three-year US treasury (~4.6%) isa good starting point. Government debt is considered risk free since, through the power of taxation, we are very likely to get our money back.
Inflation is on the rise. To tackle inflation, central banks are raising interest rates to slow demand. Rising interest rates are raising our discount or hurdle rates and as we know, this has the direct impact of lowering the PV of our investments. What does this mean to us as investors and what is the call to action?
1) Accept the Reset – interest rates were too low for too long. In some form, interest rate increases had to happen.Consider what is happening now in capital markets is a housecleaning exercise that is getting ride of excess speculation and valuations. The balance of your portfolio has been reset to a more reasonable level. Accept it and move on.
2) Cash is King Again – investments that have near term and predictable cash flows are going to have higher valuations that those with future and less certain cash flows. Why? Because the discount or hurdle rate in PV calculation has gone way up. Look no further that the over4% increases in rates in just 12 months. Stocks like grocers, rails and utilities with near term and relatively predicable cash flows will hold up well and have the added benefit of passing cost increases onto customers. Technology, biotech and other businesses that are important to our future but have profits way off in the future are going to get crushed by the increase in rates and hence the discount rate in PV calculations. Most of us invest through tools such as mutual funds and ETFs, simply review your original reason for investing with your portfolio managers and stay invested in the conviction holds.
3) Watch the Curve – the yield curve is a valuable weathervane. The yield curve maps bonds yields with bond maturity. Normally its lopes up since the longer a bond is to maturity the more inherent risk and investors want to be compensated by a higher yield. Today it is inverted. That means investors are expecting a recession and lower future interest rates. As investors, all we need to know is we are going to have to invest through a slowdown. It might get a bit messy but long-term investors take note, adding to positions during a downturn will have some of the largest returns for us over the lifespan of our investing plans.
4) Fixed Income is Cool Again – widely tracked bond indexes are down across the board. If you have bond positions, consider adding. If you don’t need the immediate cash flows, consider turning on dividend reinvestment plans (DRIP). You bond holdings might be way down, but it feels better when the current holdings are adding new units at a lower price while you wait around.
For investors, the prevailing interest rate is like gravity. A constant and fundamental force on all things in capital markets. Understanding the basics of PV and the yield curve will help us be more educated investors. In the end, the Q Wealth Portfolio Managers may decide not to make changes to the portfolios, but will have the knowledge to be opportunistic in the current environment.