Why Interest Rates Might Not Matter

There has been plenty of chatter over the past few months on when the US Federal Reserve will start tapering its stimulus efforts (known as Quantitative Easing). The Fed’s Chairman Ben Bernanke first gave a hint of a slowdown in QE back in late May, which caused a pullback in stock markets around the world.

Our local stock market barometer, the Straits Times Index (SGX: ^STI), is a testimony to that effect, as it has fallen by more than 10% from a high of 3,465 points in 22 May 2013 to its current level of around 3,100 points after Bernanke’s comments.

Lately, more fuel has been added to fire as the markets start speculating on potential candidates to take over Ben Bernanke once he steps down next January. One such candidate is Larry Summers, a former Treasury Secretary of the United States.

According to economists at French bank BNP Paribas, it would not be good news for the US if Summers takes over the reins of the US Federal Reserve.

Their rational is based on their reading of Summers’ preference for a more drastic slowdown in QE, which would lead to higher interest rates, which would in turn mean “slower economic growth and less job creation.”

If US’ economy is harmed, given its standing as the world’s largest economy, would it not portend some gloom ahead for the rest of the world?

Well, all this sounds plausible theoretically. But, investors should note that the economy of any country- much less the global economy – is a giant and massive machine of innumerable moving cogs. It’s hard to even tell if interest rates will rise in the future, much less predict what higher interest rates will actually do to the economy.

For instance, according to Morgan Housel from The Motley Fool USA, in the 20 years ended 2012, “traders have been predicting the end of low interest rates in Japan for nearly two decades, and for nearly two decades, they’ve been wrong.”

What this tells us is, it can be a futile exercise in trying to predict the end of QE, the movement of interest rates, and their general impact on the markets. I found this quote on page 127 from a re-reading of a classic investment book Margin of Safety that sums up my thoughts (emphasis mine):

There is no correct level of interest rates. They are what the market says they are, and no one can predict where they are headed… Like many other financial-market phenomena there is some cyclicality to interest rate fluctuations. High interest rates lead to changes in the economy that are precursors to lower interest rates and vice versa.

Knowing this does not help one make particularly accurate forecasts, however, for it is almost impossible to envision the economic cycle until after the fact.”

For those unaware, Margin of Safety is out of print and currently fetches prices higher than US$1,900 per book from Amazon. Its author is renowned value investor Seth Klarman, CEO and President of investing firm Baupost Group, who has led the firm to average annualised returns of 20% since 1983. Such credentials make Klarman’s views well worth noting.

Another prominent investor, Warren Buffett, was also recently quoted as saying “QE is like a good movie, because I don’t know how it will end,” signalling his cluelessness about the future of the economy.

But crucially, despite not knowing what the after-effects of QE will be, that didn’t stop Buffett from investing.

Buffett controls the US-based conglomerate Berkshire Hathaway (NYSE: BRK-A, BRK-B) and the company has to file a form 13F with US authorities to detail changes in its stock holdings. And over the course of the second quarter of 2013, Buffett has been buying up shares of different companies like the American banks Wells Fargo, U.S. Bancorp, and Bank of New York Mellon, as well as oil & gas industry player National Oilwell Varco.

Buffett has amassed his fortune, last estimated to be around US$53.5b by Forbes in March 2013, by rational and intelligent investing through Berkshire. He has an almost laser-like focus on the microeconomics of a business which entails an intimate understanding of what makes a particular business tick.

Buffett devotes his time to understanding a company’s financials, customer relationships, products, and future plans etc. in order to determine if it carries a significant economic moat that can allow it to earn supra-normal profits for significant periods of time.

Then, he decides on a purchase based on how much lower the current market price of the business is in relation to his estimate of what the business is worth after a careful appraisal of its microeconomics. That’s what Buffett focuses on in investing – identifying great businesses at cheap or fair prices. That’s all that matters to him.

Another super investor, Peter Lynch, even went as far as to urge investors to “stop trying to predict the direction of the stock market, the economy, interest rates, or elections, and stop wasting money on individuals that do this for a living.” To Lynch, all an investor had to do was to “study the facts and the financial condition, value the company’s future outlook, and purchase when everything is in your favour.”

To put it simply, at the end of the day, it doesn’t matter whether interest rates goes up or down. What matters is whether a business you’re interested in has an economic moat and whether its moat can be seriously affected by changes in interest rates.

For instance, real estate investment trusts (REITs) might see adverse operating conditions if interest rates rise due to possibly onerous interest payments for newly-acquired debt. On the other hand, companies with recession-proof businesses and pristine balance sheets – with minimal, or zero debt – like vehicle-inspection firm Vicom (SGX: V01) and healthcare provider Raffles Medical Group (SGX: R01) might well weather any interest rate changes as they do not require access to debt.

Ultimately, investors must be aware that different companies react differently to different economic environments due to their own unique microeconomic characteristics. There will be some companies that aren’t bothered with whether interest rates rise or fall and can grow their businesses steadily over time.

If you can find them, interest rates would matter no longer.

Click here now  for your  FREE subscription to Take Stock Singapore, The Motley Fool’s free investing newsletter. Written by  David Kuo ,   Take Stock Singapore  tells you exactly what’s happening in today’s markets, and shows how you can GROW your wealth in the years ahead.  

The Motley Fool’s purpose is to help the world invest, better. Like us on Facebook  to keep up-to-date with our latest news and articles.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing owns B-Class shares in Berkshire Hathaway in addition to shares in National Oilwell Varco and Raffles Medical Group.