How an interest rate rise will change the investment landscape

Interest rates are at a three-century low and have been stuck there for over a year. Your bank deposit account pays so little interest you probably don't even bother to look at the statements any more. The interest on your mortgage is so minuscule you might well wonder why the building society goes to the hassle of collecting it.

Indeed, rates are so pitiful that it may well appear bonkers to start speculating about the end of the era of cheap money. But a fascinating new study by the McKinsey Global Institute has looked at the trends at work in the global capital markets over the last three decades, and looked forward a decade or so as well. It concludes that we may well be close to a turning point.

The standard explanation for why money has grown so much cheaper over the last two decades has been the existence of a huge glut of savings, mainly from big economies such as China and Japan. But while true, that hasn't been the whole story. There has also been a steady decline in investment. Investment as a share of global GDP fell from a peak of 26% back in the early 1970s, to a recent low of just 20% of GDP in 2002. It has bounced around that relatively low figure for most of the last decade, according to McKinsey's calculations. Now, though, it might be about to take off again.

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The world goes through occasional mega investment booms. The industrial revolution, for example, or the post-war reconstruction of Europe and Japan. It may be on the brink of another one. New countries are industrialising fast, and creating new cities at the same time. Across Asia, Africa, Latin America and eastern Europe, there is a soaring demand for new infrastructure. Roads, railways, water systems, homes and factories are all being built at a rapid pace. That requires vast quantities of capital. Indeed, the rate of global investment had already started to rise quite quickly. From 2002 onwards, it climbed sharply, before being choked off by the global recession. As the economy recovers it will start growing again, probably back to the peaks seen in the early 1970s.

On the other side of the equation, global saving may well start to fall. China is probably not going to save as much in the next decade as it did in the past. Typically, as economies grow more mature, they save less and consume more. There is no reason for thinking that China will be any different. The same forces will be at work in other big emerging economies, such as India and Brazil. At the same time, populations are rapidly ageing not just in the developed world, but in places such as China as well. Typically, older people don't save. Rather, they tend to live on their past savings.

Add it all up and there will be a much higher demand for capital and a lower supply of it. You don't need to know much about economies to figure out that means prices will go up. But by how much? No one can say for certain. McKinsey estimates that 1.5% could be added to long-term interest rates. But it could be much more. For investors, that is going to make a huge difference in several ways.

First, the bond markets will go into long-term retreat. Although the equity markets get far more attention, the bond markets have been in a two-decade bull market. You'd have been better off for most of that time invested in bonds than shares. With the cost of capital hitting record lows, fixed-income investments just grew steadily more attractive. But rising long-term interest rates will reverse all of that. Bonds will enter a bear market.

Second, equities will be far more mixed. On the one hand, the cost of capital for companies will rise. And shares won't benefit from investors switching out of low-yielding bonds. That 5% dividend that looked so attractive when a ten-year bond yielded 3% won't look so great. Against that, costs such as pension funds will be easier to finance. Equities will do okay, but will hardly shine.

Third, it will have a huge impact on the capital markets. The hedge fund and private-equity industries have boomed as investors have looked for alternative strategies in a world where real interest rates kept falling. But with rates rising, plain old deposit accounts at the bank will look a lot more appealing. There's not much point in paying a hedge-fund manager 20% for some exotic, high-risk strategy when you could be making a perfectly decent return just by parking the cash in your local building society. The alternative-investment industry faces being wiped out.

Finally, it will affect the rest of the economy profoundly. The credit boom of the last two decades was fundamentally about money being very, very cheap. They were giving the stuff away almost literally in the case of some credit-card companies. Consumers and governments steadily ran up bigger and bigger debts, often without much of an idea how they would ever pay them back. Those days are over. Governments will have to balance their books, and so will consumers.

The bottom line? In a world in which capital is in short supply, people will have to go back to living within their means, and saving up for things that they want to buy or invest in. Now that really will be a big change.

This article was originally published in MoneyWeek magazine issue number 517 on 17 December 2010, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.