Navigating interest-rate rises

Loose monetary policy has driven investors to take unnecessary risks, says John Stepek. The tightening process may be ugly.

900-pyramid-634

Irrational risks become tempting if conditions are right
(Image credit: This content is subject to copyright.)

Loose monetary policy has driven investors to take unnecessary risks the tightening process may be ugly.

One big mystery that remains about our recent era of ultra-low interest rates and money printing (quantitative easing QE) is the question of the exact impact it has had on investor behaviour. Financial commentators often talk about the "reach for yield" whereby low interest rates encourage investors to take more risks simply to generate some income, rather than because they believe those risks are actively worth taking.

Why does this matter? If markets are efficient and investors dispassionately bet on future outcomes while incorporating all available data into their decisions, then they shouldn't "reach for yield" at all they shouldn't be pumping money into riskier assets just because they feel aggrieved by the incredibly low nominal rates available on safe assets, because that's irrational. Of course, as we all know, investors aren't narrowly rational and markets aren't perfectly efficient.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free
https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

And as Chris Dillow notes in Investors Chronicle this week, several academic studies suggest that once interest rates fall below a certain level (it varies depending on the study), investors are indeed willing to pile into an asset that didn't previously appeal to them, even if the risk-reward trade-off hasn't changed.

This shouldn't be a huge surprise. Indeed, it's the main mechanism by which QE works. The whole point is to push investors into riskier assets by forcing down real interest rates. In effect, the cure for the post-bubble bust was to inflate another bubble. In 2009, just as central banks led by the Federal Reserve under Ben Bernanke were flooding the world with liquidity, behavioural investment expert James Montier wrote about a 2002 experiment by Nobel prizewinner Vernon Smith.

Smith and his team found that investors who had been caught out by bubbles and busts previously would trade more cautiously in future except, that is, when monetary conditions were so extraordinarily loose they felt they had little choice but to trade more aggressively. "If the environment is one of high liquidity a bubble can be sustained despite experience," as Smith put it.

Of course, as Dillow notes, if investors have been reaching for yield, the logical conclusion is that, once rates reach a certain level, share prices will take a hit. For example, Leon Cooperman (see below) suggests that a 3.5% yield on the US Treasury bond could be enough to tempt investors back into "less risky" assets. This is another reason to expect central banks to raise slowly and, where possible, lag inflation rates. But navigating a world where rates are rising will certainly be a lot trickier than investing in one where rates are coasting smoothly downhill.

I wish I knew what Ebitda was,but I'm too embarrassed to ask

Earnings before interest, tax, depreciation and amortisation (Ebitda) is a way of measuring profit that can make it easier to compare the valuation of two companies. Ebitda may be helpful when it is difficult to compare firms using other profit measures such as earnings per share (EPS) because they have very different levels of debt, different tax rates or different accounting policies on, for example, the depreciation of fixed assets.

Ebitda measures a firm's profitability before these factors are taken into account. The two businesses can then be compared on a like-for-like basis by taking their enterprise values (EV the market value of all their shares in issue, plus net borrowing or less net cash) and comparing this with Ebitda. The lower the EV/Ebitda ratio, the cheaper the company essentially it's like a price/earnings (p/e) ratio, but using a different measure of earnings and taking account of debt.

Ebitda first came into common use in the US in the 1980s during the boom in leveraged buyouts (LBOs), as a measure of the ability of a company to service a higher level of debt. This had a major impact on what a prospective buyer would be willing to pay. Over time it became popular in industries with expensive assets that had to be written down over longer periods of time. Today it is commonly quoted by many companies.

Ebitda can be useful when combined with other analysis tools, but it has become an overused and abused measure of value. Its strength that it represents profit before various costs is also its weakness, because it doesn't represent profit that can be paid to investors (as opposed to helping private-equity buyers to gauge how much debt a firm could be loaded up with). EPS isn't perfect, but at least it allows for replacing assets, depreciation, paying interest on borrowings, and paying tax all of which reduce how much profit ends up in investors' hands.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.