CIARAN RYAN: Financial markets across the globe are pricing in multiple interest rate hikes for the year. What impact will this have on bond and equity prices? High interest rates generally result in low stock valuations, and low interest rates generally result in high stock valuations.
Joining us to help understand what this means for investors is Adriaan Pask, chief investment officer at PSG Wealth. Hi, Adriaan. Central banks have recently been forced to respond to excess demand, exchange-rate weaknesses and soaring inflation, and we saw at the end of January the South African Reserve Bank raising the repo rate to 4%. The US Federal Reserve is expected to increase Fed rates in March this year.
This follows a list of other key central banks that have started to normalise the cycle, albeit from a different starting point. How do higher interest rates impact bonds and equities?
ADRIAAN PASK: I think that’s the million-dollar question for anybody who has an offshore investment at the moment. It’s been a key area for investors over the last 10 years, increasing offshore exposure as sentiment locally went backwards very quickly. But I think this is a good time to reconsider that specific point.
If we look at where interest rates are now, they are at historic lows in the US, and what we expect to take place over the next six months in particular should have a profound impact on investments. We are expecting 25-basis point interest rate hikes in [the US in] March, May, July and September and December for this year. Then, in addition to that, obviously we’ve had the tapering that took place last year. Initially the bond repurchases tapered off at $15 billion a month, then were escalated to $30 billion a month; that should come to an end in March.
Following that we should see interest rate hikes, as I said. Then also [what is] very important to take note of is the policy statement by the Fed that was issued last month [January], which clearly states that they are aiming at running off the balance sheet, so reducing the balance sheet. That’s going to be extremely profound. I think the impact of that alone is probably going to be even more severe than the interest rate [hikes]. So what we’re saying is the days of ‘helicopter’ money being pushed out into the economy are over, and essentially what’s happening is, ‘we are vacuuming all of that up and there will be less available on the ground’.
If we look at the impact on sentiment, it’s going to be quite significant. Investors are going to realise that investing is not as easy as it used to be, and there’s not enough to spend, or not as much left to spend.
If we look at bonds, what we do in our environment and in the research team, is to consider the risks as well when we invest.
If we look at a 30-year bond, for example, we’ll stress-test that for a 1% increase in interest rates to get a good sense of how much risk we are really talking about.
In our model the 1% increase in interest rates should probably cause a 20% decline in the US 30-year bond, which is quite a significant number. On the shorter end it may be less. So, if you look at the five year [bonds], or less, a 5% decrease, but still it’s material in an environment where cash rates are barely above zero, and in real terms negative.
Then on the equity side things look equally dire. On aggregate the S&P looks extremely expensive to our minds. There’s still a lot of concentration risk in the index as the tech space has really taken up a lot of the growth in that index. As interest rates go up, you mentioned, we should see lower valuations. So we should see these stocks de-rate, so start trading at lower multiples, which is obviously part of the pressure. If we use that 30-year Treasury number, I see a 20% decline. We expect equities to be even more harshly punished than a 30-year bond, especially on specific stocks.
Obviously not all stocks are the same. But the point is that the 60:40 model – where investors used to simply invest 60% in US equities and 40% in US bonds – is going to be severely compromised.
I think the key message out of all of this is to say investors will have to taper their own expectations of what investments will be able to do in foreign markets over the coming decade.
CIARAN RYAN: All right. It looks like you are pricing in five interest rate hikes of 25 basis points in the course of this year in the United States. That of course is going to make it more expensive to borrow, and one would then expect that equity prices are going to drop, as you’ve already mentioned. But why do you think it’s important for central banks to normalise interest rates?
ADRIAAN PASK: I think that’s a really important dynamic to understand. So, if you sit back as a man on the street and say, ‘Well, listening to the amount of harm that interest-rate hikes will have on the economy and on investments, why on earth are we even considering it? Just keep rates [lower] for longer; all seems to be going just fine’. The key to remember is that first and foremost, [in terms of] monetary policy, interest rates [are] a policy tool for making sure that the economy keeps on humming along and growing at a sustainable pace.
You don’t really want your economy to run too cold. That was the Covid scare, and in that situation you stimulate, you decrease rates. But on the other end you also don’t want your economy to run too hot, because what happens in that environment is that you see bubbles forming, and there are already quite a few pundits who say there are multiple bubbles around as a consequence of having this easy money floating around. So it is time to pull back on that so that you can avoid introducing more into the global financial economy.
The other component we should expect is [that] it’s just a matter of time before the next crisis hits. It’s a bit of a grim outlook on things. I say this objectively, but there’s always something that happens, that creates some major pull-back in markets or a major pull-back in the economy. If it’s not an oil crisis, or an emerging-market crisis, or a global financial crisis, or a pandemic, there’s always something en route. We don’t know what it’s going to be, but there’s always something en route.
I think where we are now is that policy makers are extremely exposed because interest rates are so low that, if something hits us now, how are they going to stimulate with monetary policy? We are already at critically low levels. So you need to get your monetary policy into a position of readiness where you can respond [and] stimulate again.
I think that’s really on the mind of policymakers at the moment: normalising the rates so that you can essentially reload your policy-stimulus tool. That’s really the key thing.
CIARAN RYAN: On that point, how close do you think markets are to a correction?
ADRIAAN PASK: It’s such an emotive question, really. Even if you go through the research, you will see there’s a very wide range of opinions on this available. But to try and cut through the noise, what we in the research team at PSG Wealth do, is to look at this objectively by looking at the key drivers of corrections.
Historically the things that matter most would be, obviously, valuations: where corporate earnings are, what the output gap is in GDP – that’s really the potential of the economy in relation to where it’s currently growing – unemployment rates, inflation rates, and the shape of the interest-rate curve, the yield curve.
There’s a lot of technicality around that, but those are generally the things that we put into our model to try and assess how those specific factors position markets in subsequent years. So we go and look at historical data; we test various market outcomes for various levels of the combination of these variables that I mentioned.
To cut a long story short, if we look at this today, the model says there’s an 84% chance of a correction in US markets currently. It makes intuitive sense, because valuations seem stretched. Unemployment levels are at record lows. It’s creating some wage pressure, which is creating some inflation pressure, which should translate into interest rate hikes and a change in the yield curve that is not going to be favourable for investors.
So that’s really where the model is, essentially affirming the intuition that we have around these things. I think the risk is material, but that’s not to say that I think it’s very easy then to deduce that ‘I should put all my money into cash’; that’s certainly not what we are telling investors. We are saying two things. The one thing is to prepare yourselves for tougher conditions and volatile markets, so lower returns than you’ve received in recent years, more volatility than what we’ve seen over the last 10 years; and be prepared to look beyond US borders, which I think most investors have found very difficult.
If you look at institutional investors, many of them still have a lot of US-centricity built into their portfolios and that will have to change if you want to reduce risk and keep up with your goals.
CIARAN RYAN: A final question, given all these risks and the potential of a correction – where do people put their money? What advice do you have for investors, particularly in managing these risks?
ADRIAAN PASK: It’s always difficult to give advice. That’s something that our wealth managers can help each specific client with, because each client’s conditions are different, with different circumstances. But I can give you an indication of what I think is important and the things that are on our minds as an investment team.
We are paying very careful attention to valuations at the moment. We anticipate a rotation from growth to value.
That’s becoming increasingly likely. We are bearing in mind how rising interest rates will impact profit margins and profit growth, margin growth in various businesses, and how the various businesses will react. We try not to overpay for optimistic growth estimates or unsustainably high profit margins.
Following from that you need to consider how your portfolio will behave in a high interest rate environment. It’s something that’s very easy to miss because your portfolio has done so well over recent years and you don’t want to do anything – just to keep it there. But I think what you should at least be asking is: ‘Are my underlying managers preparing themselves for a tougher environment, and what have they done to combat that or to prepare for that?’
Lastly, maybe what we are also trying to do is to consider something beyond US borders. So don’t be as US-centric as portfolios have historically been; we’ve also been in that camp where US markets have done phenomenally well for us. But I think the opportunity set is definitely narrowing in that environment. So cast the net a little bit wider and be open to looking at neglected areas of the market on the regional and sector level – things that aren’t really within the focus of investors just yet, because there are still so many investors flocking to the perennial favourites from previous years, the tech stocks in particular. When that tide goes out where will the money go? I think that’s really for us to figure out at the moment, and we think it’s going to go to some of the less-loved areas from previous cycles.
CIARAN RYAN: Adriaan, we’re going to leave it there. That was Adriaan Pask, chief investment officer at PSG Wealth.
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