With interest rates rising, and quickly, the driving force that has dictated financial market decision-making for the past fifteen years is disappearing. In a flash, disoriented investors have been exposed to a new world, one that requires dramatically different expectations of what constitutes a decent return. However, despite all that has changed, it can be hard to accept that the era of ever-lower interest rates is truly over. Deep down there may be a tacit acceptance of the changing winds, but it is often coupled with denial about what it all means. The hope, it seems, is that the damage has already been done. Tech stocks have rallied and housing prices have finally started to fall in Canada. However, the liability created by rising interest rates is difficult to contain and will therefore likely ripple through financial markets, hitting everything from private equity to blue-chip stocks. Such a sea change can be hard to fathom. Since the global financial crisis of 2008-09, investors of all stripes have become accustomed to ever-declining interest rates. By July 2020, the yield on the 10-year US Treasury note, a benchmark for financial markets, had fallen to a paltry 0.52%. The trend was so absurd, such a departure from historical norms, that it even spawned a new mantra: “lower for longer.” Investors have learned to accept that interest rates will stay low for longer than once thought – and it has lasted so long that it has become the norm. And now, in just seven months, all that has changed, as red-hot inflation and geopolitical upheavals have forced a paradigm shift. In July, the Bank of Canada raised its key interest rate by a full percentage point, not seen since 1998. The Federal Reserve raised its rate by 0.75 percentage points a few weeks later. The reaction since then has been quite strange. The Nasdaq Composite for one, a barometer for growth stocks, is up 23% from June’s low. Investors seem to think the worst is behind us and are happy to go back to the way things were. The reality: It’s very likely there’s no going 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 subsidiary of Royal Bank of Canada with about US$50. billion in assets under management. He 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 for longer.” “Inflation will be higher for longer than we expected, 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 for a longer period of time,” he wrote. Of course, Mr. Galvin is just one 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, yet unemployment is at an all-time low. This shouldn’t happen. But in the past two weeks a number of Federal Reserve officials have given public interviews saying much the same thing. A day after stock markets rallied this week on news that U.S. inflation was flat in July, Mary Daly, president of the Federal Reserve’s San Francisco branch, told the Financial Times that investors should not so dazed While the data was encouraging, core prices, a basket that strips out volatile items such as energy costs, were still rising. “That’s why we don’t want to declare victory on falling inflation,” he said. “We’re not done yet.” Diane Swonk, chief economist at KPMG, can’t quite understand why investors are forgetting what the Fed fears most: inflation. One of the central bank’s biggest failures of the past 50 years was that it allowed US inflation to grow out of control – or “consolidate”, in economic parlance – in the 1970s, forcing the Fed to finally take drastic action to bring it back on the line. “This is a Fed that remembers the seventies,” Ms. Swonk said. “Most people in the financial markets don’t.” Especially not the twenty-something retailers who sent the stock markets soaring in 2021. Fed officials cannot say outright that they will tolerate a recession in exchange for suppressing inflation, but the 1980s are proof that they have and will. “They will raise interest rates and hold them for a while to reduce inflation,” Ms. Swonk predicts. Despite the history, there is still speculation in some corners of the financial markets that the Fed will change course. And there are some recent precedents for doing so. Twice in the past decade, the Fed and the Bank of Canada showed they were ready to take action to cool the economy, but both times the central banks ultimately backed down. They did it first in 2013, after bond investors got spooked, and then again in 2019. The big difference between now and then is inflation. Even Mike Novogratz, one of the most popular investors in cryptocurrency, the mother of all speculative assets, warned in the spring that interest rates will not fall anytime soon. “There is no cavalry coming to lead a V-shaped recovery,” he wrote in a letter to investors after the crypto market crash, citing the stock market’s quick recovery after the pandemic first hit. “Fed Can’t ‘Rescue’ Market Until Inflation Falls”. Predicting exactly how financial markets will be affected by higher interest rates is difficult, but just like unprofitable tech stocks, the asset classes that have benefited most from the low interest rate world are the ones most sensitive to shocks . Private equity and private credit, to name two, are near the top of the list. When debt was extremely cheap, private equity funds could finance their acquisitions for next to nothing. At the same time, passive investing was gathering steam, taking the shine off hedge funds and mutual funds. Private equity, therefore, became a vehicle for high returns. Earlier this year, Harvard Business School professor Victoria Ivashina wrote a paper that predicted a shake-up in the sector, arguing that those tailwinds no longer exist. “As the flow of capital into private equity stabilizes and as industry growth slows, the fee structure will compress and compensation will shift to become more performance-based,” he wrote. There are already signs that large investors are moving away from private equity. Earlier this month, John Graham, chief executive of the Canada Pension Plan Investment Board, one of the world’s largest institutional investors, revealed that CPPIB was more valued in public markets than private for now. And in a July report, Jefferies, an investment bank, wrote that big money managers, including pension and sovereign wealth funds, had sold $33 billion worth of stakes in buyouts and venture capital. funds in the first half of the year, the most on record. Private debt funds, which lend money to higher-risk borrowers, are also vulnerable in the current environment. Money has flowed into the industry over the past five years because these investment vehicles tend to pay 8 percent returns, but that return looks a lot less rosy now that one-year guaranteed investment certificates are paying nearly 4.5 percent. By no means are these asset classes dead in the water. Same thing with stocks and so many others. Rates have shot up, and quickly, but are still low by historical standards. However, there are many reasons why investors of all stripes should not expect a quick return to lower for a longer period of time. The latest inflation figures are encouraging, but they are a single data point. Who knows what kind of energy crisis Europe and the UK will face this winter and what that will do to oil and gas prices. Inflation is also not known to disappear quickly. “It’s easy to go from 6 percent structural inflation to 4 percent,” said Ms. Swonk, the economist. “It’s really hard to get from 4 percent to 2 percent.” Your time is valuable. Have the Top Business Headlines newsletter conveniently delivered to your inbox morning or night. Sign up today.
