The relationship between interest rates and economic growth

And, what happens to valuations when we forget this relationship.

Dear Reader,

Today’s newsletter covers a more technical and nuanced, but highly impactful point.

There is an underappreciated relationship between the risk-free rate of return and expectations of future economic growth. These measures influence each other in a reflexive way. As central bank’s expectations of future growth go down, so does the rate they offer. This oft forgotten point can lead to ridiculous valuations if ignored.

Proposition: The perpetual growth rate for any financial asset cannot exceed the risk-free rate.

If a company grows faster than the economy, it will eventually become the economy, and the growth rate of the economy will be the growth rate of the company. Thus, the perpetual growth rate cannot be larger than that of the economy and is thus constrained in this way.

It then makes sense to ask how we can estimate the expected growth rate of the economy? 

Central banks set rates based on their expectations of economy growth and inflation. As such, this rate can be a us…