Markets have had a rough start to the year and the pain has been created due to a change in interest rate expectations. Investors have been fretting about inflation for some time now, however the response from central banks has been that it will be transitory, and it will fall back towards their target later this year. This rhetoric from the world’s most important central bank, the US Federal Reserve, has changed. The participants of the interest rate setting committee for the Federal Reserve all provide an assessment of where they think interest rates will be in the future, which is then published every three months. The latest set of expectations had changed markedly compared to the previous set in September.
The below tables show the participants expectations for interest rates in the next few years with each dot being a participant’s view. In September the expectation for interest rates in 2022 was broadly to stay flat or rise marginally. Fast forward three months and the December expectations are notably different, with each of the next few years showing a broad agreement that interest rates will be quite a bit higher than expected in September.
This change in view has spooked markets. Inflation expectations haven’t really changed over the three months, however realised inflation (inflation being experienced today) has been higher than expected. The Federal Reserve are now clearly suggesting that they are looking at raising interest rates to try and curtail inflation. Previously, they suggested that inflation would fall back without changes to interest rates.
This has resulted in investors also expecting higher interest rates. This causes two issues; the first is that companies and consumers will suffer a higher cost for maintaining debt and the second is that future profits are discounted by a higher figure, meaning that future cashflows are worth less. Therefore, most asset classes have suffered over the last couple of weeks, especially those assets that are expecting high levels of growth and those assets that are highly correlated to interest rates, such as government bonds.
So, are we selling our high-growth assets in favour of ‘cheaper’ assets? The short answer is no. We did reduce our exposure to high-growth assets throughout last year, however we do still have some meaningful exposure. This exposure has hurt portfolio values in the last few weeks but have provided excellent returns over the last 20 months or so. We don’t think that inflation and/or interest rates will get to a sustained high level that will cause high-growth asses to continue to de-rate. As we’ve seen in the last decade, it’s much easier to talk about raising interest rates than actually raising interest rates. Markets are expecting at least three interest rate rises in 2022 in the UK and US, which would mean that interest rates are around 1%.
Central banks will not want to de-rail the economic recovery from the pandemic and will be very conscious of market reactions. The communications from central banks are very important as markets try and price-in any potential interest rate changes, therefore market forces can affect demand before any changes are actually made by central banks. This is helpful for central bankers. Whilst most central banks are ‘independent’, in reality the central bankers are appointed (and fired) by politicians. Therefore, it is much harder to make unpopular decisions, such as raising interest rates and easier to talk about it and hope market forces can do the difficult job for you.
It’s easy to see why the Federal Reserve has said that interest rates will need to rise “sooner or at a faster pace”. The US inflation rate is at 7% and the last time inflation was at that level was February 1982, at a time when US interest rates were at 14%. Today, rates are nearly zero. The big difference as mentioned above is that raising interest rates at a time of economic recovery with such high debt levels is very difficult to achieve for central banks. Investors are expecting four interest rate rises for the UK in 2022. We can’t see this happening. The Bank of England has raised interest rates three times since 2009, one of which was last month and the peak in interest rates over this period has been 0.75%. Investors love to worry and over-react and we think that is what is happening with interest rate expectations.
As we spoke about last year, the ‘easy’ money and positive fiscal and monetary policies we’ve benefited from since the start of the pandemic have come to an end. Therefore, there is going to be a wide dispersion of returns between winners and losers and investors are going to panic about more things, more frequently. This isn’t uncommon at this time of the cycle and now isn’t the time to panic but stick to the plan. The recent volatility has created the opportunity to invest in assets at more reasonable valuations and we think investors with a reasonable time horizon will be rewarded for taking on risk.
Thanks for reading and