This year, consumer prices have risen at the fastest rate in 40 years, the FTSE 250 index of share prices of the second tier of UK listed companies has fallen by around 25%, and long-term UK treasuries, bonds issued by the government commonly known as gilts, are down by around 40%.<\/p>\n\n\n\n
The levels of inflation we are seeing today are not normal and this will have knock-on effects on the prices of financial assets like shares and bonds. Specifically, if this bout of inflation brings about the end of the low interest rates of the last 30 years and the ultra-low interest rates of the last decade, then asset prices will continue to fall.<\/p>\n\n\n\n
Inflation should be good for shares and bad for bonds. This is because shareholders are entitled to future company profits, which \u2014 assuming companies can pass on increased costs to consumers \u2014 are unaffected by inflation.<\/p>\n\n\n\n
Bondholders, on the other hand, are entitled to a series of cash payments from a company or government that were stipulated when the bond was issued.<\/p>\n\n\n\n
While inflation increases dividends for shareholders, it doesn't increase bond payments unless they are index-linked. This makes shares good investments to hold during inflationary periods, whereas bonds are not.<\/p>\n\n\n\n
The idea of a dividend-inflation hedge appears to have been commonly assumed \u2013 and seemingly verified by the limited attempts to do so. This was the case at least until the 1970s when it became apparent that sky-high inflation was not resulting in comparable share returns.<\/p>\n\n\n\n
Economic theories were then updated (Lintner, 1975<\/a>) and the evidence re-examined (Jaffe and Mandelker, 1976<\/a>). This evidence suggests that asset prices adjust well to moderate and anticipated inflation. But inflation driven by output shocks that reduce the capacity of an economy (as in times of pandemics and wars) has a negative impact on asset returns (Danthine and Donaldson, 1986<\/a>).<\/p>\n\n\n\n Whether the 2020s will echo the 1970s is unknown. The inflation we are seeing today has been driven by factors that reduce economic capacity: pandemic-related supply constraints and soaring energy costs.<\/p>\n\n\n\n Asset prices may fare worse this time. The monetary policy context is different from the 1970s, with inflation being explicitly targeted by an operationally independent central bank. Under inflation targeting, which started in 1992, the average bank rate \u2013 the rate charged by the Bank of England for lending funds to commercial banks \u2013 has been 3.4%, compared with 5% for the 297 years that preceded it.<\/p>\n\n\n\n Lowering interest rates has been the monetary policy response to economic and political uncertainty for a generation. For example, they were dropped from 6% to 4% in 2000-01 in response to the dotcom bubble and 9\/11, and from 5.5% to 0.5% following the global financial crisis of 2007-09. More recently, they were lowered from 0.75% to 0.1% in 2020 in response to the Covid-19 pandemic.<\/p>\n\n\n\n But central banks have a history of delivering either price stability or financial system stability. In the long run, they have not been effective at delivering both (Goodhart, 2011<\/a>).<\/p>\n\n\n\n As criticism of the Bank of England mounts for not delivering on its inflation target, a period of rising interest rates closer to their historical average seems likely. This will lower asset valuations.<\/p>\n\n\n\n Higher interest rates reduce asset prices in two ways.<\/p>\n\n\n\n First, they make saving a more desirable option today. Assets and savings both transfer purchasing power through time. But because assets can lose value, they are riskier. That is why they usually offer a higher return. As interest rates on savings rise, some investors will prefer the safety of holding wealth with banks. This lowers the demand for and thereby the price of assets.<\/p>\n\n\n\n Second, higher interest rates reduce the fundamental value of assets. This is the income generated over its lifetime less the income that could have been generated if the money was put to a risk-free use. As the risk-free returns available from banks increase, the risk-adjusted returns from investing in an asset go down. This lowers the price that investors are willing to pay for an asset today. It increases the discount of future risky income: what is known as the discount factor.<\/p>\n\n\n\n While today\u2019s interest rate is known, future rates are not. It is investors\u2019 expectations of future interest rates that determine the discount factor. This is applied to assets\u2019 expected income and determines their fundamental value. As expectations of future interest rates are updated, so too is the discount factor and ultimately asset prices.<\/p>\n\n\n\n Financial markets are famously forward-looking. The market that pronounces its predictions most loudly is the bond market. Because bonds\u2019 cash flows are stipulated at issuance, it is only their price on secondary markets that varies, thereby determining the return or yield. This allows us to infer what compensation the average buyer requires for holding debt.<\/p>\n\n\n\n But by comparing the returns or yields on shorter and longer-dated bonds issued by the same borrower with little likelihood of default (mainly stable governments), we can infer what the average buyer thinks will happen to interest rates \u2014 the compensation for holding debt \u2014 in the future.<\/p>\n\n\n\n If the return from investing in a two-year bond is less than the return from a ten-year bond, this indicates that the market anticipates that short-term interest rates over the next two years will be higher than those over the subsequent eight years.<\/p>\n\n\n\n This means that the average investor thinks that central banks will aggressively cut interest rates to lessen the impact of an impending recession. In the United States, each of the last six recessions has been preceded by ten-year yields being higher than their two-year equivalents. That is what we are seeing in the UK today.<\/p>\n\n\n\n There are two important things to note. First, the market is predicting a recession. That is bad for shares, but it will already be priced in because valuations are based on what investors expect will happen in the future.<\/p>\n\n\n\n Second, the average investor believes that interest rates will rise in the short term but fall in the medium term. The current official bank rate is 2.25%. Current bond prices suggest that this will continue to rise to over 4% before falling back to today\u2019s levels.<\/p>\n\n\n\n Yet if the Bank of England's ability to achieve low inflation by affecting inflation expectations has lessened, the policy lever of interest rate rises will have to be pulled much harder to bring inflation under control. This will result in asset prices falling further.<\/p>\n\n\n\n Companies are increasing their prices at a rate not seen in a generation, leading to a cost of living crisis. But this does not necessarily mean that we have a cost of business crisis \u2013 that profits are going to fall and everyone should sell their share holdings.<\/p>\n\n\n\n For inflation to have occurred, companies must have raised their prices. This should serve as a cushion against their increasing costs. Shares have an in-built defence mechanism against the adverse effects of inflation. Yet markets are falling.<\/p>\n\n\n\n There are two mechanisms that are likely to explain this. The first is that inflation is being driven by price increases of goods that cannot be substituted: energy and food. This may insulate these sectors from the effects of inflation, but other sectors are likely to see reduced turnover as individuals direct their spending towards heat and food.<\/p>\n\n\n\n The second mechanism is central banks introducing higher interest rates to try to get inflation under control. If interest rates rise more than investors currently believe they will, asset prices will fall further.<\/p>\n\n\n\n Money is the oldest, most evolved and most important financial instrument. It is effectively a lubricant for trade \u2013 the oil between the cogs. It is involved in every trade in a transitory way. Markets need it as it dramatically increases the efficiency of trade.<\/p>\n\n\n\n Even before the introduction of cash, there are examples of societies using items such as salt, seashells or even cacao beans (in the case of the Aztecs) as \u2018money\u2019 in their trades.<\/p>\n\n\n\n The diverse and eclectic history of money is important when considering today's bout of inflation. It is just the oil in the machine \u2013 the form and denomination don't matter. That we trade in pounds, dollars, yen, chocolate, or salt doesn't alter the machine.<\/p>\n\n\n\n This has long been recognised. Inflation expectations adjust and what you can buy with your returns from investing will be determined by the risk and patience associated with investing. But people are slow to adjust their expectations and assume that the present state of flux is abnormal.<\/p>\n\n\n\n Past research has found that inflation and interest rates are correlated at a 20-year horizon (Fisher, 1930)<\/a>. With more data and more advanced research methods, subsequent studies found the lag to be about six months (Gibson, 1972<\/a>).<\/p>\n\n\n\n Whether it be instantly or with a six-month or 20-year lead, how quickly investors adjust their expectations will determine the impact of today's inflation on asset prices over the coming months and years. Investors may be being optimistic in their valuation of assets today.<\/p>\n\n\n\n The FTSE 100 is currently at its 2019 year-end level, yet inflation has been created by the reduced economic capacity following Covid-19 and the energy shock from the war in Ukraine. Further, the likelihood that interest rates return to the ultra-low levels of the recent past as central banks face a generational battle with inflation is slim, making for lower asset valuations than three years ago.<\/p>\n\n\n\nWhy do higher interest rates lower asset prices?<\/strong><\/h3>\n\n\n\n
What do investors think will happen to interest rates?<\/strong><\/h3>\n\n\n\n
How does this affect businesses?<\/strong><\/h3>\n\n\n\n
Does inflation matter?<\/strong><\/h3>\n\n\n\n
Where can I find out more?<\/strong><\/h3>\n\n\n\n
Who are experts on this question?<\/strong><\/h3>\n\n\n\n
Author: Clive Walker<\/h5>\n\n\n\n
Picture by AndreyKravv on iStock<\/h6>\n","protected":false},"featured_media":20188,"template":"","categories":[234,224,229],"tags":[1490,1492,695,629,551,552,1491],"yoast_head":"\n