With interest rates rising, and rapidly, the driving force that has dictated decision-making in financial markets for the last fifteen years is fading. In the blink of an eye, clueless investors have been exposed to a new world, one that demands dramatically different expectations of what constitutes a decent return.
Yet despite all that has changed, it can be hard to accept that the era of ever-lower rates is really over. In the background there may be a tacit acknowledgment of the changing winds, but it is often combined with a denial of what it all means.
The hope, it seems, is that the damage has already been done. Tech stocks have taken a hit and house prices have finally started to slide in Canada. But the hangover generated by rising rates is difficult to contain and, for that reason, is likely to spread through financial markets, affecting everything from private equity to blue chip stocks.
Such radical change can be difficult to understand. Since the global financial crisis of 2008-09, investors of all stripes have grown accustomed to ever-falling interest rates. By July 2020, the yield on the 10-year US Treasury bond, a benchmark for financial markets, had fallen to a measly 0.52 percent.
The trend was so absurd, such a departure from historical norms, that it even spawned a new mantra: “go down longer.” Investors learned to accept that rates would stay low for longer than was thought imaginable, and it lasted so long that it became the norm.
And now, in just seven months, everything has changed, after searing inflation and geopolitical earthquakes forced a paradigm shift. In July, the Bank of Canada raised its benchmark rate by a full percentage point, something not seen since 1998. The Federal Reserve raised its rate by 0.75 percentage point a few weeks later.
The reaction since then has been rather strange. The Nasdaq Composite Index for one, a barometer for growth stocks, is up 23 percent from its June low. Investors seem to think the worst is over and are happy to go back to the way things were.
The reality: It is very likely that there will be no turning back, at least not for quite some time.
“A lot of economists, strategists and investors think the world hasn’t changed, that we’re in a normal cycle,” said Tom Galvin, chief investment officer at City National Rochdale, a Royal Bank of Canada subsidiary with roughly $50-million in assets. under management. The disagrees. “We are in a new era.”
This summer, Mr Galvin published a paper explaining all of this, explaining why the new mantra should be ‘higher longer’.
“Inflation will be higher for longer than we anticipate, interest rates will be higher for longer, geopolitical tensions and uncertainty will be higher for longer, and high volatility in the economy and financial markets will be higher. high for a longer time”. he wrote.
Of course, Mr. Galvin is just a voice, and everything in economics and finance is so chaotic right now that it’s almost impossible to call anything with 100 percent certainty. In Canada, inflation is at its highest level in nearly 40 years, but unemployment is at a record low. That’s not supposed to happen.
But in the past two weeks a number of Federal Reserve officials have given public interviews saying almost the same thing.
The day after stock markets rallied this week following news that monthly US inflation was flat in July, Mary Daly, president of the San Francisco branch of the Federal Reserve, told the Financial Times that investors should not be so dizzy. While the data was encouraging, core prices, a basket that excludes volatile items like energy costs, still rose. “That’s why we don’t want to declare victory over reducing inflation,” he said. “We’re not done yet.”
Diane Swonk, chief economist at KPMG, can’t understand why investors are forgetting what scares the Fed most: inflation. One of the biggest failures of the central bank in the last 50 years was allowing US inflation to grow out of control, or “entrenched” in economic parlance, in the 1970s, forcing the Fed to take drastic action to bring it back online.
“This is a Fed that is reminiscent of the 1970s,” Swonk said. “Most people who trade in the financial markets don’t.” Especially not the retail traders in their twenties and thirties who sent the stock markets soaring in 2021.
Fed officials cannot openly say they will tolerate a recession as compensation for crushing inflation, but the 1980s are proof that they have and will. “They are going to raise rates and hold them for a while to bring down inflation,” Ms Swonk predicts.
Despite the history there is still speculation in certain corners of the financial markets that the Fed will change course. And there are some recent precedents for doing so. Twice over the past decade, the Fed and the Bank of Canada signaled they were ready to take action to cool the economy, but both times the central banks ultimately backed down. They did so first in 2013, after bond investors freaked out, and then again in 2019.
The big difference between now and then is inflation. Even Mike Novogratz, one of the most popular investors in cryptocurrencies, the mother of all speculative assets, warned in the spring that rates will not fall any time soon. “No cavalry is coming to conduct a V-shaped recovery,” wrote in a letter to investors after the crypto market crashed, referencing the stock market’s rapid rally after the first hit of the pandemic. “The Fed can’t ‘save’ the market until inflation falls.”
It’s hard to predict precisely how financial markets will be affected by higher rates, but like unperforming tech stocks, the asset classes that benefited the most from the world of low rates are the most susceptible to tremors. Private equity and private credit, to name two, are near the top of the list.
When debt was ultra cheap, private equity funds could finance their purchases for next to nothing. At the same time, passive investing was gathering steam, taking the shine off hedge funds and mutual funds. Private equity, then, became a vehicle for outsize returns.
Earlier this year, Harvard Business School professor Victoria Ivashina wrote a paper predicting a shakeout in the industry, arguing that these tailwinds are no more. “As the flow of funds to private equity levels off and industry growth slows, the fee structure will compress and compensation will change to be more performance dependent,” she wrote.
There are already signs that major investors are turning away from private equity. Earlier this month, John Graham, CEO of the Canada Pension Plan Investment Board, one of the world’s largest institutional investors, revealed that CPPIB saw more value in public markets than private ones so far. And in a July report, Jefferies, an investment bank, wrote that top money managers, including sovereign wealth and pension funds, had sold $33 billion worth of stakes in buyouts and venture capital. funds in the first half of the year, the largest amount on record.
Private debt funds, which lend money to riskier borrowers, are also vulnerable in the current environment. Money has poured into the industry in the last five years because these investment vehicles tend to pay 8 percent returns, but that return looks much less rosy now that one-year guaranteed investment certificates pay nearly 4.5 percent.
By no means are these asset classes dead in the water. The same goes for stocks and so many others. Rates have risen rapidly but remain low by historical standards.
However, there are many reasons why investors of all stripes should not expect a rapid downside performance any longer. The latest inflation data is encouraging, but it’s a single data point. Who knows what kind of energy crisis Europe and the UK will face this winter, and what effect it will have on oil and gas prices.
Inflation is also not known to go away quickly. “It’s easy to go from 6 percent core inflation to 4 percent,” said economist Swonk. “It’s really hard to go from 4% to 2%.”
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