When Rates Rise, Look Out Below

A Warning From Buffett's "How Inflation Swindles the Equity Investor"

The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds...

Stocks…are perpetual. They have a maturity date of infinity.

— Warren Buffett, "How Inflation Swindles the Equity Investor" (1977)

Any investor ought to know the risk of long duration investments: that they are highly sensitive to interest rates—meaning if interest rates rise, they have the most to fall in value.

Why is this?

Imagine two bond investors:

• A: Buys a 0.1% coupon government bond of 2 year duration

• B: Buys a 2% coupon government bond of 30 year duration

Per Bloomberg, these “opportunities” are available now. Now suppose short duration interest rates rise in 2 years from current nil to 4%. A’s principal has been returned and can be reinvested in new 4% (or higher) notes available. B is stuck with 2% notes which trade at discount to the price B paid for them just 2 years prior.

Investor A gets to change their rate of return much sooner than B who is stuck for 28 more years at 2%. A has more optionality and less fragility than B. This is highlighted by Buffett:

[B]onds eventually come due. It may require a long wait, but eventually the bond investor gets to renegotiate the terms of his contract. If current and prospective rates of inflation make his old coupon look inadequate, he can refuse to play further unless coupons currently being offered rekindle his interest. Something of this sort has been going on in recent years.

— Warren Buffett, "How Inflation Swindles the Equity Investor" (1977)

Why does B’s notes trade at discount to B’s purchase price if rates rise? Because there are no buyers willing to buy 28 year 2% yield to maturity bonds at par when there are 4% yielding short term notes available at par. That note will have to be discounted so that the end yield to someone buying it matches 28 year rates on prevailing notes (which is likely more than 4% per annum due to the yield curve).

What would the culprit be for rates to rise as in our scenario? That would be a recently elusive phenomenon known as inflation. A central bank’s response to inflation—price stability is one of its “dual mandates”, after all—is to raise interest rates. If the central bank has set short term rates at 4%, inflation is likely at least 4% (in reality probably much higher given the “dovishness” of current central bankers). This means bondholder B is actually losing money in real terms, with a real return of at best negative 2% (2% - 4% = -2%), but probably significantly less than that. If inflation rises further, the loss grows.

So, the fragility of the long term lender should be apparent in terms of rates and inflation.

What Does This Have to Do With Stocks?

Buffett’s 1977 “How Inflation Swindles the Equity Investor” contains a startling observation, relating stocks to bonds:

Stocks, on the other hand, are perpetual. They have a maturity date of infinity. Investors in stocks are stuck with whatever return corporate America happens to earn…As a group, stock investors can neither opt out nor renegotiate.

— Warren Buffett, "How Inflation Swindles the Equity Investor" (1977)

In other words, an equity investment is the ultimate long duration investment. The implication here should strike alarm in any equity investor: stocks have extreme sensitivity to interest rates.

With the declining rates of the past decades, the earnings yield that equity investors are willing to accept has declined with rates. In other words, the price of stocks has risen, with larger multiples justified by the low rate environment. The current GAAP earnings yield of the S&P 500 is estimated to be in the vicinity of a measly 2.5% (or a P/E of 40). And real world “adjusted earnings” (not those promoted by corporate managers) is unlikely to be much higher. Holding out hope for 2021 earnings to raise this figure significantly upwards is foolish given the predominance of tech in the S&P: a sector that largely averted (and in many instances benefited from) the ravages of 2020.

Earnings yield has been declining of late, but one should remember it is highly sensitive to interest rates due to the equity risk premium inherent to stocks.

Earnings Yield Must Rise with Interest Rates

If you have the choice between a government note that yields 6% per annum over 10 years where the government has the option of printing money to pay you (virtually no default risk), would you choose that investment versus an equity security that makes no profits yet promises profitability in 6-10 years?

Investors by and large will reach for the yield in this case. As far as equities, they will largely be tempted if they offer a yield significantly more than prevailing fixed income opportunities. This is the equity risk premium—that investors demand a larger premium to allocate capital towards stocks compared with government bonds

What happens if interest rates rise? Stocks, by definition, should trade at a larger earnings yield (premium) than risk free fixed income. Earnings yield must rise, which means stock prices must come down.

If short term government rates are 4%, stocks must yield more than 4%, likely significantly more than this number (P/E of 25 or lower). If earnings yield goes from today’s 2.5% to 5% without a change in earnings, stock prices are cut in half.

Tech is Vulnerable: When TINA Leaves, the Party’s Over

Today’s tech investor has grown dangerously accustomed to decades of falling interest rates dating back to the 1980s that have provided a consistent tailwind for equities. When a certain trend persists, investors succumb to recency bias, believing those conditions will continue indefinitely.

As the saying goes today, “There is No Alternative” (TINA) to buying these securities because yields on everything else are suppressed. As a result, profit has been deferred far out into the future by tech investors in names such as TSLA. It’s clear that yesterday’s and today’s profitability does not matter to such investors, who choose to value businesses on revenue or other multiples instead. Such investments would find few buyers at current prices in a world that offered 4% “risk free” short duration rates. Aesop’s wisdom on the subject with birds and bushes dates back thousands of years.

What’s more is the vicious economic cycle that occurs with high rates: it becomes harder for businesses to raise capital (equity or debt). Businesses that are over levered or rely on capital markets will struggle. This is why high rates cause harsh recessions--just ask Paul Volcker or Margaret Thatcher.

Many tech firms rely on equity investors who have capital around with no other alternatives. They often even pay their employees in equity that depends on generous equity markets. If rates rise, this money will find other opportunities and the well will run dry for firms that rely on such capital on their march towards a profitable day somewhere far in the future.

Conclusion

To be clear, it’s a matter of “when”, not “if” interest rates rise. Many issues are priced for a world of persistently low interest rates. The conservative equity investor should be wary of downside risks built into prevailing equity prices that are only made to last in a low rate world.