The benchmark US Treasury bond yield spiked from 1.35% in early July to about 2.50%; almost a 100% increase in 7 months! Will rates continue to spike with the so-called “reflation trade”? How would the interest rate change impact the valuation of various asset classes and investor choices?
Interest Rate Signals, Fear, and Greed
Interest rates are key to understanding asset class pricing. Rates signal economic expectations. Businesses, governments, and individuals re-examine their assets and liabilities and adjust their risk and return preferences to reflect these expectations. Short-term expectations can create speculative fever: “I need to buy now so I can get rich!” Or “I have to sell now before it makes me poor!” Fear and greed rule market pricing and it’s easy to get caught in the emotional tug of war.
If predicting market movements were only about numeric calculations, math professors wouldn’t be in the professing business! It’s seldom a simple calculation. Generally, when rates decline, money will move to riskier assets seeking a higher return. When rates are rising, risk appetites may ease as investors accept higher bonds yields and stability.
However, since the election, rates have spiked, US stocks have climbed, and bonds prices have sunk. Bonds reaction to rising rates is predictable. Bonds are “fixed-income” meaning its coupon rate remains the same when interest rates move; however, when rates rise bonds prices decline because newly issued bonds have higher coupon rates, and are more valuable to investors.
US stock market valuations were expensive before Trump was elected; the Trump stock market rally has made stocks even more expensive. The speculation is that lower taxes, fewer regulations, and increased infrastructure spending will ignite corporate profits, consumer spending, and economic growth. The bet is that profits will rise, making prices reasonable. The risk in this bet is a harsh market decline if one or more item doesn’t conform to plan.
What Does It Mean for Your Business Valuation?
Investors will eventually engage in the stability vs. return tug of war. Central bankers have announced intentions to end quantitative easing and are looking to increase rates. It’s still in question. However, if rates rise many will trade bond stability over stock volatility as a reasonable tradeoff. This could create less demand – and lower valuations – for both public and private equity.
The rate increases mean an increase in the cost of money. The “build-up method” appraisers use begins with the US T-bond and “builds up” a required rate of return based on multiple risk factors. If rising rates bring higher revenue and profit growth, valuations may stay elevated. However, if growth expectations weaken, tax cuts don’t materialize, or inflation erodes profits, it most likely will have a downward push on business valuation – both for public and private markets.
Jerry Matecun helps business owners to understand their business may have a range of values depending upon buyer type. His primary emphasis is on helping owners think through both personal and business planning issues. For a no cost, confidential conversation regarding your business valuation needs call or email Jerry at 949-273-4200, 616-499-2000, or jerry@compoundvalue.com.
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