Why the rising cost of capital matters for investors

The government paid more to borrow £4bn for 30 years this week than at any time since at least 1998. Importantly, however, the sale found buyers. Investors are demanding more compensation, but they are happy to lend at the right price. Capital has a cost again after 15 years in which money was effectively free. Almost everything interesting that is happening in markets today follows from this change.

• Get personalised advice on savings, investing, retirement or pensions from Fidelity’s financial advisory service

For much of the period from the financial crisis until the Covid pandemic, the risk-free rate was close to zero. That rather than today’s higher borrowing costs was the aberration. It did extraordinary things to financial markets because it took away the hurdle that any investment had to clear.

It meant that a company that simply promised high profits many years hence could command a high price today. It meant that governments could accumulate wartime levels of debt at no apparent cost. It meant property could support valuations that would become eye-watering when money once again had to be paid for.

• Get the latest market updates, ISA news and pension insights by email

Low interest rates and bond yields changed the rules by which all assets were priced. Now the rules have changed back and a return that looked attractive when cash yielded nothing looks more questionable when we can earn 4-5% while taking very little capital risk.

I think of this as the restoration of financial gravity. Physical gravity determines how the world around us behaves, and its financial equivalent does something similar in the markets. It decides how much governments can borrow, and so what they can and cannot spend. It says which projects can go ahead. It determines how investors allocate their portfolios and how long a boom or bubble can last.

When capital was free, strange things became possible. Companies with no profits could be valuable. Governments could dodge the trade offs between spending and taxation. Now that normal service has resumed, these things are not necessarily impossible. But the bar is set much higher.

The cost of capital is the common thread running through four of the most important questions for investors today.

In the bond market, it means that debt has consequences again. This is most obvious in the financing of governments. The difference between debt of 60% of GDP and 100% mattered less when governments could refinance cheaply. But the difference between a £100bn annual interest bill and £110bn adds up to a lot of politically unpalatable spending decisions.

The bond vigilantes are back because for the first time in years they have something to be vigilant about.

• Watch: Why are bond markets under stress?

Nowhere is the cost of capital more important than in AI. When a hyperscaler spends $100bn on data centres, the measure of its success is no longer simply whether or not it generates new revenues but whether the incremental returns compensate shareholders for not putting that money to work at much lower risk elsewhere.

This is why AI can simultaneously be a boom and a bubble. The technology can be transformative but still lead to disappointing investment returns. High bond yields have the potential to undermine the AI boom, with knock on consequences in economies that are being propped up to a large degree by AI spending.

• Read: AI investing: where the next winners could emerge

They also shine a light on where in the AI value chain the best investment returns will be found. Increasingly the winners look like being the businesses that use AI to become more productive rather than those that create or enable it.

Perhaps the most interesting consequence, for investors, of a higher cost of capital is the rotation that happens when there is a shift from scarce growth and abundant capital to abundant growth opportunities but limited capital.

Market leadership changes from long growth trajectories to profits in the here and now. If capital costs almost nothing, then an investor will wait for the pound earned in 2036. Once the discount rate rises, immediacy becomes valuable. So, we shift from revenue growth to high returns on capital, from companies that consume capital to those that generate it and from business models dependent on leverage to tangible operating performance.

Finally, rising bond yields make diversification less reliable but also more rewarding. For most of this century bonds and shares had a negative correlation, but bond yields were too low to be helpful in a balanced portfolio. The simple 60/40 stock and bond diversification model does not work when inflation not growth is the problem to be solved. Inflation pushes rates higher and bond prices fall, but higher discount rates also hurt shares. The two march to the same beat.

Different assets diversify different risks. Shares like strong growth. Bonds prefer falling growth and lower inflation. Commodities prefer it when inflation is rising. Gold responds to inflation and uncertainty. Cash is more useful when real rates are positive. Infrastructure and property offer other sensitivities. The important thing when capital has a cost is to ensure that you are not just diversifying asset labels but different economic risks.

Capital is going to continue to have a meaningful cost. The demands for capital are not going away. governments will continue to run big deficits and will need to refinance the debt piles they have already accumulated. AI is going to require trillions of further investment. The energy system will be an ongoing capital drain. Defence spending is rising everywhere. Everyone wants a slice of the same investment capital.

The biggest mistake investors can make is to assume that the next decade will operate according to the rules of the last one. The defining feature of the post-financial-crisis era was an abundance of almost free capital. The defining feature of the next will be competition for expensive capital. governments, companies and investors will all have to adjust to the restoration of financial gravity. No-one gets a free pass anymore. Capital has to earn its keep.

Tom Stevenson is an investment director at Fidelity International. The views are his own.

This article was originally published in The Telegraph.

Got a burning question you want to ask? Why not drop us a line. Click here to ask your question.

• Read: 7 reasons to stick with shares
• Read: Which 50-somethings must wait longer for their pension?
• Read: The hidden 60% tax rate – and how to avoid it

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Overseas investments will be affected by movements in currency exchange rates. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.