After the GFC, markets embraced “a new normal” of low and stable inflation. As a result, interest rates fell to levels not seen since the Second World War. Policymakers took advantage of what seemed like a free lunch by pushing interest rates down further and pumping up the economy with tax cuts and expanded government spending.
But that has now changed. Fiscal and monetary constraints have forced rates up – both at the short and the long end – as Governments are overly indebted following pandemic bailouts and monetary policy has been forced to contend with high inflation.
At the same time, two positive structural forces in the global economy are ending. First, President Xi Jinping of China has ended the 40-year “to get rich is glorious” era in China. Going forward, China will emphasise state-led growth, common prosperity and national security. After powering global growth for decades, Chinese economic growth is slowing and, as a result, fewer of its financial reserves will be recycled into international markets. China’s contribution to reducing global inflation in recent decades is likely to diminish.
Additionally, the geopolitical landscape is increasingly dangerous. In 1989, Francis Fukuyama developed the idea of the “End of History”. The West won the cold war and that was meant to mark the triumph of liberal democracy. But geopolitical conflict and tensions are back with a vengeance, from Ukraine to Taiwan and now in the Middle East. A new landscape of greater geopolitical competition will mean more to spend on defence, higher inflation and bigger budget deficits.
Source: Financial Times
What are the implications for investors?
The dramatic rise in long-term interest rates since mid-year is a game-changer. For the past couple of decades, the term premium (the compensation that investors require to buy longer-duration assets) had been trending ever lower. Indeed, demand for long-duration assets was so large that investors were willing to pay up for yield, even to the extent of receiving a negative yield in some cases.
But where to from here? The US Federal Reserve has made it clear that zero rates are over, and probably for a long time. There will be no further quantitative easing to rescue investors when they suffer losses.
Consequently, a higher cost of capital will shorten the time tech start-ups or new ventures have to reach profitability. The trend higher in price-earnings valuation multiples usually reverses as investors face the prospect of more frequent and larger losses in downturns. That’s why October was characterised by higher bond yields and falling stock prices.
Higher mortgage rates will put housing into a slump eventually, and weigh on house prices and consumer spending. Governments will face pressure to cut deficits and have less appetite to invest in the green energy transition.
It is entirely possible that this new environment will be characterised by higher and more volatile inflation as well as a return to structurally higher interest rates. In retrospect, the last few decades look like a unique period of historically depressed interest rates after the financial crisis, perhaps not to be repeated.
Perhaps, in the future, investors will have to learn how to invest without a fiscal or monetary safety net. In other words, perhaps it’s time once again to look for high-quality companies that can grow their profitability and reward shareholders over time with a suitable mix of investing in growth coupled with rising dividend payments.
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