Who is afraid of higher interest rates?

The common market sentiment prevailing these days is that we are moving from a period of ultra-low interest rates towards higher rates – which many would refer to as a process of normalisation.

But what is normal? A rate of 10 per cent would have been the norm 30 years ago, however, nowadays 2 to 4 per cent seems to be the normal range of debate.

There is no law of physics for interest rates and it might as well be higher or lower. The questions, therefore, that come to mind are: who decides or what factors determine interest rates; and for how long? Are we too concerned about where interest rates might be headed in the coming 12 months or is it really the long-term trajectory that counts?

As new economic data comes out each day, investors incorporate this information and adjust their expectations about rates: has GDP growth been above expectations? Is inflation accelerating? How many US Federal Reserve rate hikes will there be and how is tapering affecting the supply and demand balance in the US treasury market? Will a fiscal deficit exacerbate the imbalance? Is the market being distorted?

All these questions play on an investor’s mind on a day-to-day basis.

When it comes to interest rates, the investment community has a natural bias towards short-term effects as these are most prominently projected in mainstream media. The outlook for the next 10 or 20 years rarely makes headlines. Psychological studies show that the more frequently you are exposed to a certain type of information the more importance you place on that information. This is the case with an investor’s exposure to news, which by its very nature focuses on current events.

As opposed to that, individuals should be more concerned about the long-term trends - when saving for retirement or for kids’ college education, for instance. Over the long-term, secular trends are most likely to determine your investment success as compared to daily market fluctuations. Let us therefore take a look at long-term trends for a change, and our ability to make predictions over very long-term horizons.

One might think that predictions for the next six to 12 months already have a high margin of error, so how could one possibly rely on any long-term prediction? There is one trend though which is very predictable and highly relevant for answering these questions: demographics.

If you look at one specific cohort, for example the "Baby Boomer" generation born in the mid-1940s to mid-60s, a good investment strategy would have been to follow their life cycle spending needs: from diapers to education, from their first car to home ownership and finally to health care and retirement cruises. The demand was quite predictable as you knew exactly how many people there were and at what age they were likely to demand various services and products.

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For some products and services this was easier while for others, in particular new ones, such as personal computers, smartphones or social media, this was a bit harder. However, if you don’t look at one generation in isolation but all the generations within a society in aggregate, Baby Boomers, Generation X, Millennials and so on, the predictive power is fascinating.

One important prediction you can derive is about the labour force, which will be shrinking in most developed countries as more old people are exiting the labour force than young people entering it. You can also estimate the ratio of the labour force size compared to the dependable population. In other words, how many non-working people have to be supported by each working person?  This ratio will go up and spare capacity for innovation will likely go down.

Also, you would have a good idea about the dynamics in savings and investments. If you know that a large part of the working population is at peak savings age, and they outweigh borrowing by young professionals or divestment by retirees, then savings may exceed new investment opportunities and competition for lucrative yields will drive yields lower.

These trends can be calculated due to the abundant amount of demographic data available about births and mortality rates as well as spending and savings behaviour across age groups. Other important factors, like migration and technological advancement, can be modelled separately. These factors are less easy to predict but generally do not change the general message.

Coming back to interest rates, what does it mean?

Gross domestic product growth is a function of labour force growth and productivity growth. Hence developed countries will likely experience low growth rates for the next decade given current demographic trends. Depending on country-specific demographics this will be more pronounced in fast-ageing societies like Japan and Germany but will also be very noticeable in the US. Increasing levels of savings will continue to chase investment opportunities. As a result of low growth and higher savings, interest rates should be anchored.

There are two major implications of these trends for investing purposes. Firstly, interest rate benchmarks in developed countries are unlikely to create a significant headwind to global asset valuations. Secondly, you should look out for favourable demographic trends to support your investments if you want to generate above average long-term returns.

Robert Hahm is chief executive, head of asset management at Mashreq Capital, which is a member of The Gulf Bond and Sukuk Association