Higher interest rates and asset prices

Amid the frantic noise that accompanies Wall Street analysis it is sometimes only too easy to miss the obvious. Today market commentators and the public are generally bullish about the outlook for shares and house prices. Yet this flies in the face of common sense.

Short term interest rates rose by 0.25% last week in the US, the seventh rise since last June, bringing discount rates to 2.75%. Moreover, the comment that followed the announcement made it perfectly clear that more rises are coming and that inflation is now a threat.

What ultimately determines the value of an asset is its return relative to interest rates. Share dividend yields can be low if interest rates are low; house rental yields can be low if interest rates are low.

But if interest rates go up then dividends on shares are worth less by comparison and so share prices generally fall. Likewise if the cost of a mortgage goes up then the value of a house has to fall to compensate for the increased cost of money and the relative decline in rental value.

So you need to be a real optimist to think of higher interest rates as a bullish indicator for shares and house prices.

There is the argument that higher interest rates follow strong GDP growth and that this is good for asset prices, but it is not a particularly good argument as in six out of the past eight phases of sustained US interest rate rises a recession has followed.

Perhaps this is why sales of shares by directors of US quoted companies have rocketed in the past year, while the public has been blissfully optimistic. Contrarians would suggest public and stock market over-optimism is also a classic sell signal.

So let us not loose sight of the basic rules of investment. It is the same blind optimism that says the record high US trade and budget deficits are a good thing. Such imbalances have to be corrected sooner or later, and the plain fact is that currency adjustment alone will not be sufficient to take this pain.

Again it is a matter of simple mathematics. The longer you run a deficit the worse things become and you end up paying interest on the interest payments and so on. There just has to be a point where you correct a trade deficit by stopping importing so much, and a budget deficit by spending less on health, education or social services.

But what applies in US capital markets is also relevant to the soaring GCC stock and real estate markets. The vertical upward movements of recent months are simply unsustainable; markets can not go vertically upwards for very long, and a correction is generally a painful experience.

At this stage investors would be advised to lighten-up on stocks, real estate and even bonds - which also perform badly against interest rate rises. Safe currencies, precious metals and non-industrial commodities look the best place to stash cash for a rainy day which can not be far away.