“The past is a candle at great distance: too close to let you quit, too far to comfort you.”

― Amy Bloom

A collective delusion about interest rates has consumed us for the past year. After years of describing interest rate levels as unprecedented we now seem to believe that it is our birth right to have them hover slightly north of zero. It is time for investors, bankers, politicians, and homeowners to accept reality. Clinging to the past is not doing any of us any good.

I’ve read it all. It all started with the folly that we had evolved past the relationship between low interest rates and inflation. The world had changed as deflationary forces including globalisation reversed. Yet we insisted inflation was transitory. We assured ourselves that interest rates couldn’t go higher because homeowners would have to cut spending. But Phillip Lowe doesn’t care if heavily indebted consumers need to cut spending. That is his goal. That is how we beat inflation.  

We spent 2022 in a Panglossian stupor. Bad economic news led to market rallies in the hope it would lead to interest rate cuts. After a series of disastrous early stumbles central bankers have been clear about their intentions. Interest rates would keep going up until inflation is under control.

The impacts of rising interest rates are delayed. But from where I’m sitting inflation does not seem under control. It just accelerated in the UK. At home we recently got the “good” news that the UBS grocery price tracker only increased 8.8% in February after going up 9% in January.

We’ve spent the last two weeks worried about the banks. US banks have $620 billion in unrealised losses from bonds sitting on the books. Silicon Valley Bank is no more. Credit Suisse has been absorbed by it’s rival for $3 billion. It was worth $45 billion in 2018.

The supposed good news about the banking crisis is that many commentators believe it will cause slower increases in interest rates or even a pause. The Federal Reserve has added credence to this view by reducing the latest interest rate increase to 25bps. Maybe this will continue to play out. Maybe not. It doesn’t matter. A year from now will interest rates be back to COVID levels? Certainly not. We need to start getting used to interest rates that are more in line with the average over the past 33 years. That is an RBA cash rate of 3.84% which is still higher than our current level of 3.60%.  

The impact of interest rates on asset values

The passage of time provides a certain clarity to events. In hindsight it will seem obvious that the era of low interest rates ended in March of 2023 when central banks started lifting rates. But in the muddled present that clarity is lacking. We are still very much in denial about what is happening.

The level of interest rates impact the valuation of almost every asset. Shares, bonds and property are all worth less in higher interest rate environments. And we have seen movement in prices to reflect this. The US share market fell significantly last year. Bonds have dropped. Residential real estate has pulled back following the surge during COVID.

Yet acceptance of the end of the easy-money period still eludes us. Part of this may be reflex. Part may be wishful thinking. But each share market rally is led by the same no-profit tech companies that did so well in the COVID era. Housing prices are continually forecast to return to the heights of 2021.

Private assets are yet to feel the impact of interest rate increases

Private assets are always going to lag publicly traded markets. This inertia is not all bad. Public markets can swing wildly as they are driven by the emotions of investors and the vicissitudes of traders. Yet we are starting to reach a point where stubborn valuations may be at odds with reality.

Private equity is a good example. A simplistic description of private equity is that a relatively small pool of investor capital is combined with massive amounts of debt to buy companies. The cost of the debt will play a big role in the return earned on an investment. In a higher interest rate environment, a private equity investor would have to pay less for future acquisitions if they wanted to earn the same returns.

Paying less for future acquisitions would have a cascading effect. The valuation of any asset is ultimately driven by transactions. In public markets transactions occur thousands of times per day. I know what my shares are worth because they trade on a liquid market. I can see what people are willing to pay for them every minute of the trading day.

Private valuation changes are much less frequent. But the actual amount people are willing to pay for assets becomes apparent over time. The irony is that a disciplined private equity investor will demand lower prices for new acquisitions. That very act will make the book of assets they hold worth less.

Another great example is commercial real estate. We can use publicly traded REITs as proxy to look at the underlying value of the property held by REITs. The value of their holdings is captured in the Net Tangible Assets (“NTA”). That is supposed to represent what an investor could expect to receive if they owned the REIT outright and sold off all the assets.

The REIT sector has significantly underperformed the market. The Vanguard Australian Property Sectors ETF (ASX: VAP) is down over 25% since January 1st 2022. This compares to an 8.5% drop of the ASX 300 over the same period. One reason is that investors understand that higher interest rates depress property values and don’t believe they are captured in the NTA of the REITs.

Our analysts cover 21 Aussie REITs. If we remove the two fund managers in the sector - Goodwin Group and Charter Hall - our coverage universe is trading at a 25% discount to NTA. The AFR reports that REST Super recently pulled an office building that was up for sale in Melbourne off the market. The reported reason was bids came in 15% below the value REST carried the asset. Our REIT analyst Alex Prineas cautioned “an NTA is often not a measure of value, it is a barometer of recent transactions.” This is at least one high profile case where a transaction at a bid below NTA was not consummated.

The next shoe to drop

Private assets are making up more and more of industry super fund portfolios and represent over 20% of the average My Super option. Private assets like commercial property and private equity. Private assets like start-ups which most closely resemble the Vanguard MSCI International Small Cap ETF (ASX: VISM) which is down close to 16% since the 1st of January 2022.

We don’t know what assets they hold in their portfolios because they legally don’t have to disclose them. We don’t know the valuation of these assets. All I know is that my Aussie Super High Growth pre-mixed fund is up over 6% since June 30th 2022. A fund that holds 21.5% of the fund in unlisted private assets.

The impact of higher interest rates will continue to ripple through global economies. They will pop up in unexpected places. Unexpected places like a bank few people in Australia had heard of two weeks ago. I have a feeling they will pop up in the performance of my super fund in the not too distant future. I think other investors with exposures to private assets will feel them as well.

I’m comfortable with a higher interest rate environment as I didn’t partake in the debt fuelled speculation that overtook markets and consumers during the COVID period. What I am not comfortable with is continuing to kick the can down the road. It is time for the denial to end.