Reining in the boom helps keep it going

Everywhere you look interest rates are either heading higher or at least, as in the US, not falling having previously risen.

In the past rising interest rates have been bad news for stock markets. Indeed I used to have a rule that the only things that make share prices fall are rises in interest rates. One thing is for sure; this rule no longer works. On the contrary interest rates and asset prices have been happily climbing together for several years.

An unbiased observer would be forced to one of two conclusions. He might think either that higher interest rates actually cause asset prices to rise or that there is some underlying factor making interest rates and asset prices rise together.

Set up and monitor your share portfolios here

Higher rates can prevent crashes
The first hypothesis, that higher interest rates cause asset prices to rise seems counter-intuitive but, on examination, is not such a silly idea. In the late 1990s continuing into early 2000 there was a dramatic investment bubble in technology shares. Bubbles lead to crashes. It would have been better for most people if that bubble had never happened. In that respect investors should be pleased to see global interest rates going up if they help to prevent new investment bubbles from developing.

There is another positive side to higher interest rates that I have touched on before. The higher rates go the more scope there is for them to fall if economic growth slows down or goes into reverse. Look at the awful example of Japan where economic activity stayed in the doldrums even with zero interest rates.

In both the UK and US there is already considerable scope to cut rates if needed in the event of a slowdown. In that respect investors are right to react positively to rising interest rates; within reason the higher the rates compatible with healthy economic growth the better. We don’t want our growth to be dependent on artificially low interest rates.

Set up and monitor your share portfolios here

Just the right temperature - not too hot and not too cold
The underlying factor that could make both interest rates and asset prices rise together is healthy economic growth. The ideal economy is one growing at a sustainable rate with interest rates set at a level to prevent that healthy growth from triggering inflation. This is sometimes described as the ‘Goldilocks’ economy, not too hot and not too cold. Recent statements from Federal Reserve chairman, Ben Bernanke, who seems to have stepped remarkably neatly into former chairman, Alan Greenspan’s shoes, suggest that he thinks the US is behaving in a ‘Goldilocks’ way.

Even better news might be the thought that perhaps the whole world economy is on a ‘Goldilocks’ growth path and that, because of globalisation, that sustainable growth path is much faster than it was in the past. Sustainable fast global growth appears to have a leveraged effect on wealth creation with huge numbers of new middle classes aspiring to own their own homes and needing savings and a sharp increase in the number of seriously wealthy individuals bidding up the price of scarcer assets.

This leads us to the present combination of circumstances where steady growth in the global economy is triggering powerful asset price booms scaring central bankers into nudging interest rates steadily higher. It is a fun game and it could go on for a good while yet. The danger is that asset price inflation will spill over into general inflation triggering a vicious circle of higher wages chasing rising prices as happened in the 1970s and 1980s. The end result is that bankers have to slam on the brakes with interest rates rising far above normal levels triggering meltdowns in equity and property markets and soaring yields on long-dated bonds as governments compete for scarce liquidity.

Set up and monitor your share portfolios here

No need to slam on the brakes
Fortunately I don’t think we are anywhere near this nightmare scenario. Central bankers in the new millennium have learned the lessons about inflation. Unlike in the 1970s they know that if you wait until higher inflation is clearly visible the battle to contain it has already been lost. Pre-emptive strikes are vital and they are making them.

Since 2003 Greenspan, Bernanke and UK Bank of England Governor, Mervyn King, have used every excuse to push interest rates higher. UK interest rates did fall, once, against the background of stagnant house prices and slumping consumer spending, but even then it was clear that the fall happened over King’s dead body. He is a classic central banker, much keener to apply the brakes that to pour fuel on the flames.

All the above brings me back to my headline about ‘reining in the boom’. As long as the central bankers keep their feet on or close to the brakes there is every chance that this globalisation-fuelled boom will run and run enabling asset prices to keep climbing perhaps to astonishing levels in a few years time. Over-heated markets will correct like UK property prices in 2004 and 2005 or US property prices now. Supply and demand can come back into balance, perhaps at a new higher level of interest rates, and the rising trend in asset prices can continue.

This leads to my other theory that the real constraint on growth is the planet itself. We have learned how to generate economic growth without causing accelerating inflation. Now we need a new kind of sustainable growth, one that does not consume the planet’s resources or pollute the environment. I believe humanity will rise to the challenge. The solutions themselves will be a source of exciting investment opportunities.