With all the talk (and reality) of inflation over the past 12 months, many investors have become deeply concerned about the future of their portfolios.
Make no mistake. What I’ve written here is dry.
The concepts I present are huge when it comes to understanding investing though – and they provide a lot important context for what’s happened over the past year in financial markets. They also provide some clues as to where we might be heading next.
One of the responsibilities of modern central banks (like the Federal Reserve) is to undertake a variety of activities which help keep inflation within a specified range. This is known as inflation targeting – and it is achieved primarily by either raising, or lowering interest rates. This relationship is not direct though.
If inflation has risen outside the acceptable range (as it recently has), there is actually no direct action that a central bank, or anyone else, can take to keep it in check. In fact, the only thing anyone can do is to deliberately cool the economy in the hopes that inflation will then subside. Cooling the economy is usually achieved by either reducing government spending, or by raising interest rates.
When investors worry about inflation, it’s not actually inflation itself they’re worrying about. They’re actually worried about rising interest rates. Let’s look at why.
There are two main reasons that rising interest rates scare investors:
1. Volatility can be penalized.
2. Future cash flows are worth less in today’s money.
There are two main ratios for analyzing the quality of a particular risk. These are the Sharpe Ratio and the Sortino Ratio. The purpose of both is to examine the trade-off between risk and return. They do this by looking at the volatility of an asset (the extent to which price fluctuates), the growth in price – and something called the Risk Free Rate (usually the yield on the US 10 year government bond). If interest rates rises, the risk free rate rises, and the risk you take by holding a volatile asset can end up looking very unattractive.
Now to the value of future cash flows…
A cash-producing asset, like stock in a major company, can be valued by making assumptions about how much cash it will produce in the future. Those future cash flows are then discounted. The higher the discount rate, the less the future cash flows are worth today. There are a number of rates one can use to discount future cash flows, but they are all influenced by interest rates.
Figuring out how much a particular asset is worth is often more art than science. There are big swings in sentiment which can drive the price of an asset to well below, or way above, what one might consider reasonable.
If we take the view that the US economy will continue to strengthen and inflation continues to remain high, there could be even more pain to come for riskier assets. Many of these assets have been aggressively sold off over the past 12 months due to the expectation that a slew of rate rises are coming (some are now predicting up to 7). One could argue that these rate rises are now quite well priced-in.
If we take the view that inflation and growth could quickly cool though – and if interest rate rises follow a shallower path than many are expecting – some of those riskier assets are actually looking extremely cheap. Especially the ones with explosive growth prospects.
When we talk about raising interest rates in the context of what’s happening at the moment, we’re talking raising a handful of times, over the space of a year or more, in increments of probably no more than 0.25%. Doesn’t sound like much, but it’s actually really significant.
And now you know why :)
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