Investing in an era of high interest rates and scarce capital
by Brian Neeley December 8, 2022 in Market
Investing in an era of high interest rates and scarce capital
Welcome to the end of cheap money. Stock prices have been through bad times, but rarely have so many asset markets been so bloody at once. Investors find themselves in a new world and they need new rules.
The pain has intensified. The S&P 500 index of major US stocks was down nearly a quarter to its lowest level this year, wiping out more than $10 trillion in market value. Government bonds, usually a haven from stocks, have been destroyed: Treasuries are headed for their worst year since 1949. By mid-October, the 60/40 portfolio split between US equities and Treasuries had fallen more than in any year since 1937. Meanwhile house prices are falling everywhere from Vancouver to Sydney. Bitcoin has crashed. Gold did not shine. Commodities alone had a good year – and it was because of the war.
The blow was worse because investors had become accustomed to low inflation. Following the global financial crisis of 2007–09, central banks cut interest rates in an effort to revive the economy. As rates fell and stayed down, property prices rose, and the “all-in-all boom” took hold. From its low in 2009 to its peak in 2021, the S&P 500 rose sevenfold. Venture capitalists wrote ever bigger checks to startups of all kinds. The worldwide private market—private equity, as well as property, infrastructure and private debt—quadrupled in size to more than $10 trillion.
This year’s dramatic reversal was triggered by a rise in interest rates. The Fed has tightened more sharply than at any time since the 1980s, and other central banks have pulled back. Look deeper, though, and the underlying cause is resurgent inflation. In the rich world, consumer prices are rising at their fastest annual pace in four decades.
This era of high money calls for a change in how investors approach the markets. They are scrambling to adjust to the new rules as reality sets in. They should focus on three.
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One is that the expected return will be higher. As interest rates fell in the bull year of 2010, future income was converted into capital gains. The downside of higher prices was the lower expected returns. Symmetrically, there is a silver lining in this year’s capital losses: future real returns have gone up. It is easiest to understand this by considering Treasury inflation-protected securities (TIPS), whose yield is a proxy for the actual risk-free return. The yield on ten-year TIPS was minus 1% or less last year. Now it is around 1.2%. Investors who held those bonds during that period suffered huge capital losses. But higher tips yields mean higher real returns in the future.
Obviously, no law dictates that asset prices that have fallen this much cannot fall further. Markets are jittery as they await signals from the Fed about the pace of interest rate hikes. A recession in the US will crush profits and drive down share prices to risk averse.
However, as Warren Buffett once argued, potential investors should be happy when stock prices fall; Only those planning to sell soon should be happy with the higher prices. Nervous or illiquid investors will sell below, but they will regret it. Those with the skill, courage and capital will take advantage of the high expected returns and thrive.
The second rule is that investors’ outlook has narrowed. Higher interest rates are making them impatient, as the present value of future income streams is falling. This has jolted the share prices of technology companies that promise bountiful profits in the distant future, even as their business models are starting to show their age. The share prices of the five largest tech firms included in the S&P 500, which make up a fifth of its market capitalisation, have plunged as much as 40% this year.
As the tide shifts away from new firms and towards old ones, seemingly burnt-out business models, such as European banking, will find a new lease of life. Not every new firm will be short of funds, but checks will be smaller and check-books will be less frequently branded. Investors will have less patience for firms with heavy upfront costs and distant profits. Tesla has been a huge success, but older car makers have suddenly gained an edge. They can get cash flow from past investments, while even qualified disruptors will find it hard to raise money.
The third rule is that the investment strategy will change. A popular approach since 2010 has mixed passive index investing in public markets with active investing in private markets. This saw huge amounts of money flowing into private debt, which at its peak was worth more than $1trn. Roughly one-fifth of the portfolios of US public pension funds were in private equity and property. Private-equity deals make up about 20% of all mergers and acquisitions by value.
One side of the strategy looks vulnerable — but not the part that many industry insiders are now inclined to deny. To its critics, index investing is a bust because tech companies tend to be larger in indices, which are weighted by market value. In fact, index investing will not disappear. It is an affordable way for a large number of investors to achieve above average market returns.
where to worry
It is those high fee private investments that deserve scrutiny. The performance of the private properties has been highly praised. By one estimate private-equity funds marked up 3.2% of the value of those firms globally, with the S&P 500 shedding 22.3%.
It is largely a mirage. Because the assets of private funds are not traded, managers have wide discretion over the price they charge. They are notoriously slow to mark these down, probably because their fees are based on the value of the portfolio. However, the declining value of listed firms will eventually be felt in privately owned businesses as well. Over time, private property investors who thought they had survived the crash in the public markets would also face losses.
One group of investors must come to grips with a new regime of high interest rates and scarce capital. It will not be easy, but he must take a long-term view. The history of the New Normal is on its side. It was a time of cheap money which was strange.
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Source: news.google.com
