There are some uncomfortable parallels between the state of economies and markets today and previous challenging periods in recent financial market history. These have provided material for eye-catching newspaper articles in recent weeks including The Telegraph’s ‘Why Britain is on the verge of a cataclysmic financial crisis’. In this note we examine the validity of such parallels, offer our views on the outlook for developed economies and investment markets, and outline the resulting portfolio positioning. Our view is that, given the rapid pace of interest rate increases in developed economies and the resulting bond market turmoil, equity markets are skating on thin ice.
We begin with a brief economics refresher.
The Theory
Central banks are raising interest rates to bring inflation to heel. Higher interest rates mean higher financing costs which act as a brake on economic activity, thereby reducing inflationary pressures. The brake operates through companies and households: both are forced to think twice before borrowing at higher interest rates to fund investment or consumption. Meanwhile, those with existing borrowings pay more in higher interest costs and so their spending elsewhere is squeezed. Even in the public sector, higher borrowing costs mean government spending comes under pressure as a larger portion of revenue goes to make interest payments on debt. Thus, economies slow, inflationary pressures ease and price stability is regained.
That, at least, is the theory. The challenge is that interest rates are an extremely blunt tool. While it ought to be possible to use them to bring inflation back to target without denting economic growth too much, history offers very few successful examples of this fabled ‘soft landing’.
The Uncomfortable Parallels
We now move on to consider briefly the parallels mentioned in our introduction. Comparisons have been drawn between the current economic backdrop and that in 1987, just prior to the Black Monday stock market crash. In both periods interest rates and bond yields were rising to cool economic growth and thereby bear down on inflation. Also, in both periods, the stock market continued to show resilience, seemingly oblivious to the growing burden that higher and higher interest rates put on consumers and companies. In 1987, this continued until the fateful day, 19th October, when equities suffered their worst daily fall since 1929: the US stock market plummeted by an astonishing 20% in one day, on its way to a peak-to-trough decline of 33%.
At that time a recession in the UK was staved off for a couple of years, thanks in no small part to interest rate cuts in response to the stock market crash itself. However, a downturn was only delayed, not averted: the UK went into a deep recession in 1990. Extending the comparison to other time periods, the chart below shows, for the US, that interest rate hiking cycles are almost always followed by recessions. This is because the ‘medicine’ administered to deal with inflation has the unwelcome but unsurprising side-effect of triggering an economic downturn.
Recent Experience
A final glance at the chart above reveals not just the significant scale of the recent rate hikes, but also the extraordinary low interest rate environment that preceded them. We have transitioned from a world of almost ‘free’ money to the highest rates in over 20-years, and it has happened at an eye-watering pace.
There are two interconnected points here. Firstly, the long period of ultra-low interest rates encouraged borrowers, including governments, to load up on debt. According to the Institute of International Finance, global debt has grown by $100tn in the past decade to a record $307tn by the second quarter of this year. Arguably, this was not an issue when interest rates were close to zero – but huge debt levels and high interest rates are a potent and combustible mix.
Secondly, the pace at which rates have been raised has been remarkable. The second chart below highlights the break-neck speed at which the Federal Reserve has raised interest rates over the last 19 months in an attempt to bring runaway postcovid inflation back to the 2% target. By way of comparison, rates were increased by 4¼% over two years in the run up to the financial crisis: by Autumn this year they had risen 5¼% in three-quarters of that time.
The pace of increase in interest rates is a concern as it means the full weight of higher borrowing costs has yet to be felt by consumers and companies. This is why central banks are now pausing their hiking cycles.
Together, the pace of rate hikes and the fact they come after such a prolonged period of very cheap money suggest further cause for caution. Given how seldom central banks have achieved a soft landing in the past, to do so having foisted hugely rapid rate hikes onto economies burgeoning with debt seems a very, very tall order.
Nevertheless, optimism that this aggressive medicine is working – that economies can slow gently, and inflation can return to target – has prompted a resurgence in equity markets. By contrast, bond prices have continued to fall. Bond yields (the inverse of bond prices) appear to be rising for two reasons.
Firstly, investors are beginning to believe that higher yields are justified by resilient economic growth – that economies can withstand higher interest rates and bond yields. Secondly, huge auctions of new government bonds, together with the reversal of quantitative easing, suggest that higher yields may be necessary to persuade investors to soak up the expanding supply.
To summarise, equity markets have remained resilient because economic growth has remained robust. Bonds have fared less well for the same reason; robust economies mean higher interest rates appear justified. But this is a paradox: the further long-term bond yields rise, the more likely it is that economic growth will suffer.
Outlook and Positioning
In our view, the chances of a happy ending to central bank campaigns to cure inflation are increasingly slim, and equity investors’ optimism increasingly misplaced. As higher interest rates and long-term bond yields make their mark, we expect equity markets will come under pressure as the economic backdrop deteriorates sharply. Briefly considering the US equity market, with valuations around 20x this year’s estimated earnings, this looks priced for perfection not peril. Moreover, the consensus of analysts’ expectations is for earnings growth of 12% next year – an aggressive pace of recovery, when we have as yet seen little by way of a slowdown. As the stock market gains this year are not being underpinned by earnings growth, we are unsurprisingly cautious on the outlook for equities and are positioned accordingly.
By contrast, we believe that now is a very good time to be a fixed income investor. For the first time in 15 years, the yields on high quality bonds look appealing. While the capital values of bonds have taken the pain of interest rates that have risen higher and faster than anticipated, ongoing holders are compensated by the attractive income now being paid. Additionally, bonds now also offer potential for capital gains should interest rates – and so bond yields – eventually retreat from current, elevated levels. This would occur in an economic slowdown or recession. It would also occur should financial accidents happen (as they did exactly 36 years ago, and as they did in US regional banks earlier this year), and also should financial markets become more concerned about intensifying geopolitical instability.
Given the dead weight of high interest rates on our hugely indebted and politically unstable world, we consider this to be a matter of ‘when’ not ‘if’. With bonds set to deliver meaningful positive returns, portfolios are positioned for such an outcome.
