Interest rate turnaround or turning point?
By Christian Schmitt, Senior Portfolio Manager at Ethenea
The lid on central banks’ box of tricks, which worked wonders for almost all asset classes over the past 13 years, will have to stay closed for the foreseeable future. Market participants will once more have to take the hit from setbacks in capital markets to a much greater extent. This is a real turning point, which investors now have to get used to.
The interest rate turnaround is on everybody’s lips – again. While savers primarily want to earn interest on their savings again, many investors are fearful of a rise in interest rates.
What a higher risk-free rate means to investors is first and foremost valuation risk for their bond, equity, real estate and commodity investments. The question is, how real is this risk? Interest rates and, ultimately more importantly, longer-term yields and the aforementioned markets are linked at two main points:
- Relative attractiveness: Investors continuously compare the risk/return profiles of various investment alternatives. The higher the absolute returns of fixed-income securities, the more attractive they are perceived to be relative to the available alternatives.
- The fundamental valuation: All future income – be it coupons, rental income, dividends, profits, revenues or expected capital gains – must be discounted to determine the present value. The requisite discount rate is obtained by combining the risk-free rate with an individual risk premium for each asset. The higher the risk-free rate, the higher the discount factor and the lower the present value of the asset.
In our opinion, the effect of both factors is currently being overestimated in the market. While yields have risen of late and thus seem much more attractive than they were a year ago at first glance, high inflation is the main driver of this development at the moment. It’s also worth bearing in mind that bonds are nominal assets. That means that an investor gets a rate of interest that is fixed today, for example, for the next ten years (in the case of a German Bund, the rate of interest would be approx. 0.14% p.a. at 28 February 2022) and would then get back the amount they initially invested, let’s say EUR 100, in ten years’ time. At this point in time we cannot say what the real purchasing power of this investor’s EUR 100 would be in 2032. With inflation most recently at 5.1% in Germany and current market expectations for inflation at 2.1% per annum for the next ten years, however, the investor can expect a noticeable loss in purchasing power. In short, considering all relevant factors, including inflation expectations, nominal bond investments remain structurally unattractive relative to real assets such as equities, real estate and commodities.
Dangerous conversion in fiscal and monetary policy
We can certainly talk of a turning point in capital markets at the moment, which will, at least for the next few years, change the face of the world of investment that equity investors have come to know and love since the global financial crisis. In this changed world, interest rates will be less of a factor than the fundamental stance of the key central banks and, in particular, the courses of action that will be open to them in the future.
In the years after the financial crisis, central banks took the sting out of many emerging economic problems using vast amounts of money. The new, expanded toolbox turned out to be a veritable box of tricks, and investors embraced it with open arms. Lightning-fast rallies on the heels of crises became the norm, and no problem seemed able to pose a serious threat. All the talk was about the Fed put, where the market believed central banks would step in when it came down to it and set prices rising again. There was a dangerous convergence in fiscal and monetary policy, even though many of the challenges were actually outside the remit of central banks and government financing by central banks is officially regarded as a strict no-no. So why was this possible for so long? Because it happened on the pretext of price stability.
For years, inflation from Japan to Europe and onward to the U.S. was below the 2% target. Unconventional measures were supposed to help us get closer to the target of 2%. And then, so as not to have to give up too hastily the toolbox investors became so fond of in the event that the 2% mark was reached, fresh arguments kept being put forward (such as expected inflation should be locked in close to the 2% mark for subsequent years as well, if possible) or monetary policy objectives were expanded and relaxed. Thus, for instance, the Fed introduced average inflation targeting1 in 2020 and the ECB also recently issued a new monetary policy strategy to be able to make more efficient use of unconventional measures in future if the situation arises.
The end of a dream world
This dream world of investment for investors, property owners and speculators could have remained intact if, after all these years and injections of money, inflation had not suddenly shot up to rates well above 2% last year. At first, it all seemed transitory, with no cause for urgency. Fed Chair Jerome Powell’s statement at a press conference in June 2020, “we’re not thinking about raising rates, we’re not even thinking about thinking about raising rates”, was much quoted.
But we now live in a different world. While only in Autumn 2021 the first rate hike in the U.S. was not expected before 2023, of late expectations peaked at up to seven rate hikes for 2022 alone. Inflation has proved to be much more stubborn, higher and broader-based than expected for a long time. In addition, due to the labour and skills shortage, a spiral of rising prices and wages threatens to set in, which could cement inflation in the coming years at levels well above 2%. To make matters worse, there are some structural developments and extraordinary factors at play at the moment, over none of which central banks have any control, which argue against inflation returning to below 2% any time soon.
What investors can conclude from sustained high inflation combined with current full employment is simple, albeit hard to swallow: the lid on central banks’ box of tricks, which worked wonders for almost all asset classes over the past 13 years, will have to stay closed for the foreseeable future, and that means no more beloved Fed put. In these changing circumstances, central banks’ mandates simply no longer lend themselves to the generous supports of the past. Market participants will once more have to take the hit from setbacks in capital markets to a much greater extent. The next time there is a setback, the external lifeline that was the norm in recent times will not be there. This is a real turning point, which investors now have to get used to. No matter whether the interest rate turnaround ultimately comes to pass or is (again) delayed.
1 As part of its long-term monetary policy strategy, the Fed introduced average inflation targeting in 2020. This strategy allows for inflation to rise and fall so that it averages 2% over the course of time.
