The past year has seen the cost of money rise rapidly as interest rates have moved from zero to 5% across the developed world.
Unquestionably, markets have not liked it. As interest rates have risen, bonds have fallen in price for the logical reason that investors demand a higher rate of return in exchange for the extra risk of lending money to companies and governments if they can earn more just by parking their money in the bank.
Companies, of course, have been hit by the rising cost of raw materials they need to build their products, and higher borrowing costs.
However, as interest rate expectations have now peaked it is right to ask an important question: If these interest rates do stay higher for longer, does that mean we can’t make good returns from shares and bonds?
The simple answer to this is: no. There is no inherent reason that markets cannot make good returns with higher interest rates. To disentangle why, we must be clear that what has hurt investment returns over the past year is not that rates are higher, but that they are travelling higher. It is the journey rather than the destination.
Bonds, for example, fall in value because interest rates are rising, but they don’t fall because interest rates remain high. Indeed, high interest rates - now they have arrived - simply require companies and governments to issue bonds with higher interest payments attached.
High rates drive up the long-term expected returns for bonds. Indeed, global government bonds held for the next ten years will make an investor close to 4% a year. Two years ago, that number was a fat zero. A portfolio of higher-risk bonds, known as high yield bonds, will return close to 7% - and that’s assuming as many of these riskier companies go bankrupt as did in the Global Financial Crisis.
There is also no particular reason why equities cannot make good long-term returns when interest rates are higher. By definition, to invest in shares investors must be rewarded with what is known as the ‘equity risk premium’. This is the excess return that investors demand for the extra risk of picking shares over safer investments like bonds or cash. If the returns from cash and bonds are higher, then the equity risk premium must also be higher. So nominal equity returns must be higher.
There is, of course, another element to this. If interest rates are so high that they are harming the economy, this will hurt the earnings of companies and, by definition, make it harder for equity markets. Yet the fear amongst bearish investors at the current time is not so much that interest rates are crushing the economy, but rather that they are not.
They worry that the ‘neutral’ interest rate - what economists call R* - has risen significantly. Therefore, they worry that the economy will continue to grow even though rates stay higher – forcing them to stay higher for longer.
We agree it is possible that R* has risen a little, but probably not as much as most people fear. If the current level of interest rates is so high that it is weakening the economy, then inflation will continue to decline and rates will fall.
Then, long-term worries about higher interest rates are mute. If higher rates are the new normal, then the economy can cope, and we should not assume it will lead to poor equity returns in the long-term. Yes, this could mean interest rates could rise a little further to damp down on inflation, and in that scenario the short-term could see further market falls. But we must also note that it is clear that this is not the current view of central bankers.
They are pausing and waiting on any further rate rises because history has taught them that there is a long lagged effect on rate rises. They will be patient to avoid causing a significant recession.
At Albemarle Street Partners, we don’t believe we can forecast the future. We believe the world is so inherently unpredictable that our portfolios thrive better by remaining highly diversified, harnessing proven market factors and understanding where the wind is currently blowing. However, it is also important to dismiss the argument that the future is bleak because of something happening now (such as high interest rates) when this argument is not supported by the evidence.
To test this argument, we can look at the last three times interest rates have peaked in the United States.
The last peak occurred on 1 April 2019. In the year following that peak, both equities and bonds rose in price steadily until hitting a dramatic wall in February 2020, when the pandemic hit and changed everything.
The previous peak was on 28 August 2006. In the year following that peak, the S&P 500 rose more than 5%. In the peak before that, in June 2000, the S&P 500 lost slightly over 10% in the following year as the gloss began to come off technology shares.
Source: Federal Reserve Economic Data and FE at 1/10/2023.
Past performance is not a guide to future performance. Capital at risk.
So, does this mean that high interest rates make equities go down? No, but it does mean it does not necessarily make them go up either.
The long-term drivers of equity markets here remained unchanged. Markets rise because economies become more productive. And so, pessimism about the future today built on interest rates being ‘higher for longer’ has little basis in fact.
It is far more productive to lift our eyes from the wobbly bicycle wheel just in front of us, focus on the distant road, and recognise that we stand at the start of an enormous wave of just the sort of productivity growth that is the real driver of market returns over the long-term. This is fuelled by a wave of technological innovation from artificial intelligence that most analysts agree will be just as powerful a driver of innovation as the advent of the modern personal computer in the 1990s.
The key challenge for investors over the next decade may be less about coping with 5% interest rates – something markets have done again and again – and more about profiting from a world that is rapidly changing, whilst avoiding the bubbles that process creates.