Global Equities

The gravity of interest rates

It matters that the market is misjudging the interest rate to use for long-term valuation purposes.

“The value of every business, the value of a farm, the value of an apartment house, the value of any economic asset, is 100% sensitive to interest rates because all you are doing in investing is transferring some money to somebody now in exchange for what you expect the stream of money to be, to come in over a period of time, and the higher interest rates are the less that present value is going to be. So every business by its nature … its intrinsic valuation is 100% sensitive to interest rates.”
Warren Buffett – 1994 Berkshire Hathaway annual general meeting

“It all comes down to interest rates. As an investor, all you’re doing is putting up a lump sum payment for a future cash flow.”
Ray Dalio, Founder Bridgewater Associates

In our view, all true investors are value investors. To be an investor, you must assess the intrinsic value of a business and compare that assessment to the price at which that investment can be purchased. Any person who buys an investment without first assessing the intrinsic value is a speculator, not an investor. In evaluating the intrinsic value of a company an investor must do two things: estimate the amount of cash a business will generate between now and judgement day; and determine the appropriate interest rate to discount the future cash flows to present value. At Magellan, we believe you can predict with more certainty the future cash flows for an outstanding business with entrenched competitive advantages than you can with a mediocre business. If we cannot reasonably predict the likely cash flows a business will generate over time, we will pass on the opportunity. You cannot properly compensate for a large error in the level of future cash flows by adopting a higher discount rate.

Given that the present value of any business is sensitive to the discount rate being used, we spend considerable time thinking about the level of future interest rates. Interest rates are the gravity of markets – low long-term interest rates support higher valuations while higher long-term interest rates suppress valuations. It is concerning that there is so much commentary opining on whether or not share markets are under- or overvalued without any discussion about the likely level of future interest rates. We can confidently predict that many stock markets are presently overvalued if future long-term interest rates are 5% or greater and also predict that they are attractively valued if long-term interest rates are 3% or less in the future.

For many years before the global financial crisis in 2008, it was reasonable to adopt a discount rate of about 9% to 10% based on a long-term interest rate of 5% and an equity-risk premium of about 4% to 5%. A proxy that investors have historically adopted for the interest rate within the discount rate (also known as the ‘risk-free’ rate) has been the yield on highly liquid long-term government bonds such as 10-year US Treasuries or 10-year German Bunds. Since the global financial crisis, greater uncertainty surrounds the discount rate an investor should adopt in assessing the intrinsic value of a business. Post 2008, the major central banks undertook extremely aggressive monetary policy – they reduced short-term interest rates to very low (and even negative) rates and purchased vast quantities of bonds by expanding their balance sheets (quantitative easing) – that has dramatically lowered, even distorted, long-term interest rates. This has made the prevailing yields of long-term US Treasuries and German Bunds unusually poor benchmarks for assessing the appropriate risk-free interest rate to use for long-term valuation purposes. We believe investors are, in aggregate, adopting risk-free interest rates at levels materially lower than prevailed prior to 2008 but higher than the current long-term yields on US Treasuries and German Bunds. We can’t say this for certain because the risk-free interest rate being used by investors in aggregate is not transparent. It is not available on Bloomberg or in a newspaper. In this regard, the uncertainty over the true risk-free rate created by the policies of the major central banks over the past 10 years has made the investment business more challenging.  

Without a reliable and transparent proxy, an investor must now make a judgment call about the appropriate risk-free interest rate to use in assessing the intrinsic value of a business. This judgement is complex and requires an investor to assess the likely level of future economic growth and inflation in particular. Both of these factors will be determined by many factors including: changes in consumption and investment patterns as populations age; the potential for future improvements in labour productivity; the impact of technological improvements; the impact of increased government debt on future consumption and economic growth; the potential trend towards protectionism; the impact of income inequality on politics, policy and labour relations; and so on.

Our best judgment is that many economies are likely to enter a prolonged period of more modest economic growth and lower inflation than prevailed over the extended period prior to 2008. We have therefore adopted a lower long-term interest rate than we have used in the past to ensure consistency with these economic views. Notwithstanding that we have adopted a lower-than-historical interest rate in our valuation models, we caution that economic cycles exist over the short term and we could experience a spike in inflation that might cause a spike in long-term interest rates. If this happened it would be highly disruptive to markets.

Important Information: This material has been delivered to you by Magellan Asset Management Limited ABN 31 120 593 946 AFS Licence No. 304 301 (‘Magellan’) and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation.  This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should read and consider any relevant offer documentation applicable to any investment product or service and consider obtaining professional investment advice tailored to your specific circumstances before making any investment decision. A copy of the relevant PDS relating to a Magellan financial product or service may be obtained by calling +61 2 9235 4888 or by visiting

Past performance is not necessarily indicative of future results and no person guarantees the future performance of any strategy, the amount or timing of any return from it, that asset allocations will be met, that it will be able to be implemented and its investment strategy or that its investment objectives will be achieved. This material may contain ‘forward-looking statements’. Actual events or results or the actual performance of a Magellan financial product or service may differ materially from those reflected or contemplated in such forward-looking statements.

This material may include data, research and other information from third party sources. Magellan makes no guarantee that such information is accurate, complete or timely and does not provide any warranties regarding results obtained from its use. This information is subject to change at any time and no person has any responsibility to update any of the information provided in this material.  Statements contained in this material that are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of Magellan. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon.

Any trademarks, logos, and service marks contained herein may be the registered and unregistered trademarks of their respective owners. This material and the information contained within it may not be reproduced, or disclosed, in whole or in part, without the prior written consent of Magellan.

How to invest

  • Magellan offers two market-leading strategies, global equities and global listed infrastructure. Find out how easy it is to invest in the world’s best companies, as chosen by Magellan’s experts.

  • Global Equity Products

    You buy from the world’s best companies, so why not invest in them? Magellan offers a range of highly-rated global equity funds, containing some the world’s best companies that we believe are positioned to benefit from long-term investment tailwinds.

    Invest in global equities
  • Global listed Infrastructure products

    Infrastructure: Supporting you every minute of every day. Our range of top-rated global listed infrastructure funds are positioned to generate inflation-protected, stable yet solid returns.

    Invest in global infrastructure
  • Magellan Sustainable Fund

    Invest in 20 to 50 high quality global companies within a framework that considers ESG risks. The Magellan Sustainable Fund aims to achieve attractive risk-adjusted returns and preserve capital in adverse markets.

    Find out more
  • MFG Core Series

    Our range of lower-cost global equity funds, designed to offer investors a unique and compelling combination of active portfolio construction and ongoing systematic portfolio management.

    Find out More
  • Magellan FuturePayTM

    Investing for income and growth, particularly in retirement. Magellan FuturePay is an innovative new fund that aims to deliver a predictable monthly income that grows with inflation, capital growth with a focus on downside protection, a reserving strategy and on-going income support, and daily access to capital.

    Invest in FuturePay