Why low rates are not good for equity returns

ONE of the most common bullish arguments for equities is that interest rates are low. The value of a share is the sum of its future cashflows, discounted back to the present day; as rates fall, the discount rate declines, so the present value must rise.

Rather than get bogged down in the theory straight away, let us start with the practice. At a recent Economist conference, we were lucky enough to have a talk from Elroy Dimson, best known for this work at the London Business School, but now at Cambridge's Judge School. Professor Dimson is well-respected for his work in market history and he produced this data on the relationship between real rates and future equity returns. The numbers cover 20 separate countries over a period of 113 years (1900-2012) and so are pretty authoritative. He split the data into eight sections; the lowest 5% and the highest 5% of real rates and the six bands of 15% between. The figures below show the subsequent annualised real returns from equities over 5 years.

                                  Returns

Lowest 5%                    -1.2% 

Next 15%                      3%    

Next 15%      ...Continue reading

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