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Alan Polley: What is r* and how it helps investors analyse rates

Our multi-asset team uses a tool called r* to get a better idea of where rates are going and what returns we can expect. Pendal’s ALAN POLLEY explains

  • The natural interest rate offers a useful tool for investors
  • Long-term returns outlook more attractive
  • Find out more about Pendal’s multi-asset funds

WHERE next for interest rates?

It’s probably the most important investment question going.

Rates have far-reaching implications for individuals, businesses and governments. They determine the cost of borrowing money and the value of investments — and they impact inflation, economic growth and employment.

Pendal multi-asset portfolio manager Alan Polley believes the key to unlocking the outlook for rates lies in comprehending the concept that there is an underlying or ‘natural rate’ of interest.

“When interest rates are low enough, they stimulate demand. And when they are high enough, they restrain demand,” says Polley.

“That means that somewhere in the middle, there must be a rate that is neither contractionary nor expansionary.

“That’s the natural interest rate — the level of real interest rates when the economy is in equilibrium.”

What is r*?

Known by economists as the r* (and pronounced ‘r-star’), the natural rate of interest is the real interest rate when the economy is at full employment and inflation is stable over a normal business cycle.

It is the reference point for how central banks manage rates across the business cycle.

Since the GFC, the r* has tended towards zero. In the boom time of the 1980s, it tended to exceed 2 per cent.

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Interest rates are fundamentally a factor of the supply and demand for capital. And over the next decade, demand for capital is likely to be higher than it has been since the GFC (though not as exuberant as the 80s), says Polley.

The energy transition and renewables rollout require substantial investment, national security is emerging as an issue that will require higher defence investment, companies are investing in rebuilding supply chains post-pandemic and governments are lifting public spending and running budget deficits.

Demographics will also play a role as ageing populations reduce available labour, forcing businesses to invest in synthetic labour like automation and AI.

“We take the view that a lot of these things mean there will be more demand for capital going forward than there has been since the GFC,” says Polley.

And as demand is rising, capital supply is falling as central banks switch from quantitative easing to quantitative tightening.

“Looking forward, we see the r* around the 1 per cent level — providing a reasonable compensation for the opportunity cost of supplying capital,” says Polley.

A 1 per cent natural rate fits neatly in an historical context, between the near zero rate of the post-GFC period and the 2 per cent rate of the three decades leading into the GFC.

It’s also a return to the very-long term natural rate, which has hovered around 1 per cent since 1900.

And it’s consistent with recent research from the US Fed and the RBA, which both assumed a 1 per cent r* in their long-term outlooks.

Using r* to understand rates

But how does that help with predicting the future of cash rates?

Polley explains that adding the r* to inflation provides a useful approximation of the long-term state of policy rates.

“In Australia, the centre of the RBA’s inflation target is 2.5 per cent. Adding the r*, that means the cash rate should end up at something like 3.5 per cent over the longer term.

“In the US, they have an inflation target of 2 per cent, which implies a long-term cash rate of 3 per cent.”

That provides investors with a powerful insight into the outlook for rates, says Polley.

“The RBA cash rate is currently 3.85 per cent — that’s pretty much in line with neutral.

“But in the US, the Fed cash rate is 5 to 5.25 per cent. That’s very contractionary.”

Potential for better long-term returns

The r* does more than help predict movements in rates, it also provides important information about the future returns for different investments.

“A higher r* means that the forward-looking return environment is higher than it has been since the GFC,” says Polley.

“Interest rates are your starting point — other asset classes’ risk premiums are added on top.

“If your base r* is low, then everything’s low.

“Reverting to a higher level means the base return for all asset classes is higher.

“Another nice aspect is valuations — with r* trending down before the pandemic we had valuations going up. High valuations mean more risk looking forward. Now, we have r* at more normal levels, valuations are back to more normal levels as well.

“These two things together mean that the longer-term return outlook looks more attractive than it was before the pandemic.

“We don’t think it’s a low-return world anymore — we think it’s more of a normal-return world.”

About Alan Polley and Pendal’s Multi-Asset capabilities

Alan is a portfolio manager with Pendal’s multi-asset team.

He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.

Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.

Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.

Find out more about Pendal’s multi asset funds:

Contact a Pendal key account manager here

This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current as at May 25, 2023. PFSL is the responsible entity and issuer of units in the Pendal Multi-Asset Target Return Fund (Fund) ARSN: 623 987 968. A product disclosure statement (PDS) is available for the Fund and can be obtained by calling 1300 346 821 or visiting www.pendalgroup.com. The Target Market Determination (TMD) for the Fund is available at www.pendalgroup.com/ddo. You should obtain and consider the PDS and the TMD before deciding whether to acquire, continue to hold or dispose of units in the Fund. An investment in the Fund or any of the funds referred to in this web page is subject to investment risk, including possible delays in repayment of withdrawal proceeds and loss of income and principal invested. This information is for general purposes only, should not be considered as a comprehensive statement on any matter and should not be relied upon as such. It has been prepared without taking into account any recipient’s personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation. The information may contain material provided by third parties, is given in good faith and has been derived from sources believed to be accurate as at its issue date. While such material is published with necessary permission, and while all reasonable care has been taken to ensure that the information is complete and correct, to the maximum extent permitted by law neither PFSL nor any company in the Pendal group accepts any responsibility or liability for the accuracy or completeness of this information. Performance figures are calculated in accordance with the Financial Services Council (FSC) standards. Performance data (post-fee) assumes reinvestment of distributions and is calculated using exit prices, net of management costs. Performance data (pre-fee) is calculated by adding back management costs to the post-fee performance. Past performance is not a reliable indicator of future performance. Any projections are predictive only and should not be relied upon when making an investment decision or recommendation. Whilst we have used every effort to ensure that the assumptions on which the projections are based are reasonable, the projections may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. The actual results may differ materially from these projections. For more information, please call Customer Relations on 1300 346 821 8am to 6pm (Sydney time) or visit our website www.pendalgroup.com

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