What if current low interest rates and consequently high asset prices are because of both supply and demand problems? Specifically demand and supply in the market for loanable funds. To quickly define terms, supply of loanable funds is what non-economists call saving/investing. Demand of loanable funds is borrowing. The price of loanable funds is interest, and as we can see there are a variety of loanable funds markets conforming to different needs of both investors and borrowers.

The price for loanable funds in the developed western world is extraordinarily low and has been for some time. That isn’t news. What’s still perplexing is why interest rates continue to be so low. Certainly the Fed and the ECB and other central banks pursuing low interest rate policies can have something to do with it, but that only explains short-term rates. Long-term rates are abnormally low, and they have gone even lower as the Fed has raised the fed funds target rate.

Well, some very interesting research from the Fraser Institute has given some legs to another hypothesis that you may or may not have heard: demographics. If this hypothesis is accurate, it has much different long-term implications than anything the central banks are doing with interest rates.

Briefly, the idea is that young people & young businesses need more financial capital than they have or can generate, so they borrow. Old people & old businesses, excuse me “mature,” have more financial capital than they need and so lend it. In a growing economy, young outnumber old meaning there’s more demand for loanable funds than there is supply and thus interest rates are positive – and sometimes very high. Of course, within the funds market there are risk factors and so on that subdivide the market, but here we’re talking about the big single factor driving all rates down.

The demographic shift that is taking place in Canada, the U.S., western Europe, and indeed most developed countries, is what happened to Japan – birth rates are way down, and people are living way longer, giving rise to a greater proportion of old to young. In addition to many other implications, this means interest rates are way down because there are ever more lenders and ever fewer borrowers – including businesses.

By the way, these demographic forces are long-term but I believe they are currently being exacerbated by the lack of real investment from the business community in developed economies. There are a variety of reasons for this, but the effect is that all that cash on firms’ balance sheets is being used to fund stock buybacks and not real investment. The shrinkage of outstanding stock leads to less demand for loanable funds and increases downward pressure on interest rates.

Now, all that said, what are the implications for asset pricing, valuation, and investing? Glad you asked! The demographics issue has implications for growth, but that is beside the point of this post. I will return to that issue in the future. Here I want to focus on the required return (interest rate) aspect of asset prices.

When we’re thinking about expected returns on assets, like bonds or stocks, we’re thinking about two things: the risk involved, and the price of the risk. Interest rates are about the price of risk. The risk we can take as a given here. When baseline interest rates are down because of some bigger factor (demographics here) then the price of all risks gets driven down. So instead of returns of 8% on stocks in general, we’re looking at 6%. Depending on the taste of risk (or risk tolerance if you will) that may not be high enough for some people. Others may be so risk intolerant that they will take whatever the lowest risk returns happen to be, thereby actually destroying real wealth since risk-free rates are below inflation. At any rate, interest rates in all categories of risk are driven down, even assuming risk spreads don’t change.

What happens when interest rates are driven down? Asset prices rise. Coupled with a shortage of assets to invest in, we get an even bigger increase in asset prices. I don’t consider this to be a bubble at all; it’s simply a reflection of economic reality. Extending the argument, asset prices that have risen because of these factors are unlikely to crash deeply. More likely, we’ll get more of what we’ve been getting: slow growth and asset prices moving sideways.

The implications for valuation are simple: looking forward, your WACC or discount rate, whatever you’re using, is probably going to be low by historical standards. But, at the same time, your growth rate might be lower too, so cap rates (return – growth) might be similar to historical experience. I’ll think through growth rates in a future post.