A Zerohedge article (21st Sept. 2023) started with the headline: “Wronger For Longer”. The next line read: “We were lower for longer. Then we were higher for longer. Now we are going to be wronger for longer”. The author argues, despite recent, improved prints around inflation (US and EZ) and higher growth projections in the US, the idea that even if rates fall in 2024, the notion they are going back to post-2008 lows is very unlikely. Their view is even if rates fall in 2024, they won’t fall fast or even far.
Previously, I wrote about the impact the expectation of higher rates on markets (bonds and equities). Now it’s worth looking at why rates could remain higher for longer…….even forever?? The environment we have been used to of low/non-existent rates, disinflation (even deflation), ultra-low volatility and high savings (boosted by the pandemic) & growing wealth (property price appreciation, stock market gains and steady wage rises) – have all but evaporated. Rates rose sharply because of fast, rising headline inflation which then fed into core inflation. Since then, inflation (headline and core) has come down. So, why all the consternation around rates – they should come down too right? There are key things analysts, economists and central bankers have missed / underestimated along the way:
The Neutral rate (R*), the rate at which monetary policy neither stimulates nor restricts growth, is not just about inflation. It is also a function of demographics, demand for capital, amount of government debt, consumer risk appetite / threshold for pain (rising prices), commodities. On top of these, there are the known unknowns (current geopolitical tensions) and unknown unknows (freak weather conditions and more geopolitical tensions).
There’s no formula for calculation it – the only way to find out what level it might be is by hiking rates and observing how an economy responds. That’s why central bankers are following the “data-dependent” line and hiking rates +0.25% at a time. The “feeling” is we are almost there. In the US, there may be one more, upward tweak – there again there might not. More interesting though is what next year’s view is and whether there will be rate cuts. Most forecasts are pushing rate cuts expectations further out.
Demographics: we’re ageing, fast! The number of people hitting the 50+ bracket is rising and they need income. Pension funds provide that income (government and private). To hedge pension fund liabilities i.e. the pensions they have to pay out, they have to match liabilities with assets (typically, but not exclusively government debt). Debt issuances are only successful if the demand is there and, in a world where risk premia is rising, buyers of government debt want a higher payout (coupon/yield). Higher cash rates are a boon too – today you can comfortably earn 5%+ on savings accounts with quick access. It all adds up.
Government Debt: most governments, many in the developed world, are torn between wanting to lower taxes while still stretching budget spending. Numerous Asian countries have announced extra budgets to help their lower-earning consumers with the cost-of-living crisis. Governments have to fund this through debt issuance. To lure buyers, they have to pay higher premiums (higher yields).
Consumers: they’re still not really feeling the pain. I have commented on this numerous times. The single, biggest liability on any consumer’s balance sheet is debt. The biggest form of debt are mortgages. For the most part (US, parts of Europe), this is fixed for multiple years at very low rates. So, if you know your outgoings and, therefore, have the interest payments covered, your home is not at risk – for now at least! That leaves the consumer to fight against rising food prices (which have alleviated somewhat) and petrol costs (which rose sharply, then fell sharply and are now rising again but not so sharply). Thanks to rising wages, they can juggle these. It hasn’t stopped them from finding the money to travel – just look at airfares and hotel prices and travel costs. The consumer presents the biggest dilemma for any central bankers – when to stop raising rates?
Commodities: The Russia/Ukraine crisis saw oil prices hit over a $100 pb. The impact on inflation was almost immediate. Then they fell back but the decline in headline was slower. Now they are on the march again and hovering over $92 pb. The latest rally will undoubtedly have some pass-through to the headline inflation print. This will, if central banks’ track record is anything to go by, keep rates elevated. That then feeds into core inflation again. How high will oil prices go? It’s worth noting, at $100 pb, it hurts everyone – including the producers because of its impact on consumer demand. Add to that, the transition to alternative fuels makes a difference at the margin – even though hydrocarbons dominate the energy scene. With pandemic savings now at about half the levels vs before, consumers will react quickly to price changes. This elasticity of demand is something oil producers are very aware of. Don’t forget their savings will be subject to even more erosion when student-loan repayments resume next month. Pickering Energy Partners forecast a range of $75 to $90 pb. We are at the very top end of that right now. Sporadically, don’t be surprised if it goes even higher hitting triple digits. It is unlikely to last but it’s the impact it has when it gets to that level – it starts of a nasty cycle of price rises. The latter then takes several months to unwind.
Hopefully, the above gives some insight into the forces skewing the risk of rates remaining higher for longer. Forever? I am not sure but certainly longer. The irony in all this is that by prioritising bringing down inflation, what central bankers have done is to curtail growth (GDP). There are three fundamental ways to cut debt: (1) cut spending; (2) boost growth or (3) let inflation run! Inflation doesn’t just eat into the value of your assets – it also easts away at your liabilities. Smart investing can limit – even profit – from the former. It’s a cheap way to shrink debt – that’s what happened in the 1970s. Instead, developed markets are hell-bent on capping GDP while reducing the power of destroying debt the cheap way. And no government can afford to cut spending. So, effectively, it is eliminating all three levers.
Portfolio implications?
My overall view has not changed:
Growth has not disappeared – that’s evident from the recent volatility in markets on the back of higher rates due to higher growth. Therefore, ‘tis a strong individual who dares to short the market! I don’t buy into the argument that central bankers don’t know what they’re doing but I do worry they are thinking too much within the box. They need to change the strings through which they control the puppet. If you’re going to cut spending then use the proceeds to cut taxes. Then incentivise consumers to save & invest. If you want to cut debt, then let other forces run free such as inflation because right now, nothing else is working.
Higher rates. For longer, particularly hurts growth stocks. This has been the main detractor in equity markets this month, especially technology. We are seeing something of a repeat of the dot.com saga. First, anything with “.com” went up. Then it came down. We are going through that now. The next stage in determining growth for technology will be (1) when we know what the real impact of AI truly brings and (2) how the value chain forms to make AI happen. Right now, it’s still forming. My colleague & cyber chief sent me this clip: https://www.youtube.com/watch?v=MVYrJJNdrEg It’s mind-blowing – the metaverse is truly forming (the nuts and bolts i.e. hardware and software companies needed to roll it out). Now imagine the applications that can be created with this (latent marketing potential!). Otherwise, there are plenty of value, quality names with margin and pricing power. So, depending on your risk appetite, stay directionally long….
….but always prepare for a big market downturn. Bonds are truly attractive. You can lock in yields of 4% and above. Emerging and High Yield will give you close to 10%. Yield is a form of downside protection – even if bonds still go down, you get the coupon which at least helps to offset some, even all, the downside. The challenge is to buy solid, quality names.
Keep cash at all times – now you get a decent yield. Short duration is attractive and a good substitute for pure cash.
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