What is normal
Many articles advocating for lower rates give the impression that current rates are both abnormal and unsustainably high. But is this really the case?
Interest Rates vs Inflation by Decade, 1950-present
Source: Federal Reserve Bank of St. Louis (Federal Funds Effective Rate, Consumer Price Index for All Urban Consumers)
The average interest rate from 1955 to the present day has been 4.63%, and the average inflation rate is 3.54%. Although both would be considered ‘high’ by current, standards, they do represent what could be considered the ‘old’ normal. In other words, it is not inconceivable that they could persist long-term.[1]
What has changed
The decade from 2010 to 2020 was a benign period for financial markets, world trade, and (by and large) world peace. Why can’t we go back to that normal?
The reasons are many and complex, but a few data points can go a long way to explaining. A large amount of the stability the US has enjoyed, including the post-pandemic recovery, has been linked to government spending, funded by borrowing.
According to some estimates, for every $1.00 of net investment, $1.90 of debt was created.[2] The US national debt has accordingly grown from 50% of GDP in the early 2000s to over 120% in the present day. Needless to say, this is not a sustainable source of growth.
Coupled with an increasingly uncertain geopolitical outlook making trade more expensive, and other drivers of higher costs such as the green transition (more expensive energy) and an aging workforce (lower tax receipts), governments have little room to bankroll growth in the way they have done till now.
Why there is still hope
While governments may have to choose between a multitude of evils, individual investors are able to target similar or even higher returns than in the so-called ‘good times’. How so?
To be sure, the higher cost of debt will weigh heavily on many companies and consumers, so depressing overall stock market returns.[3] Real estate and certain areas of the technology industry will be particularly affected, as cheap debt has played a particularly key role in valuations up to now.[4]
The bright side is that in the new environment, good companies will not only flourish as before, but will also have less competition. Whereas before an abundance of cheap capital made investors and lenders less discerning, in the future, discernment will be the path to long-term outperformance.
The technical way of putting this is that dispersion of returns will increase as the availability of capital diminishes.[5] On a macro-economic level, we are likely to see GDP growth and stock market growth ‘re-couple’, as weaker companies drop out of the running and productivity, rather than debt, becomes the main driver of growth.
The future-ready strategy
For the adaptive investor, there is no true ‘worst case scenario’, as even in a negative-sum game, there are winners.
The ability to identify sectors that will not be subject to the oncoming headwinds, and more importantly promising management teams and value propositions within those sectors, is not only a feasible strategy, but an essential one.
Of course, executing it is more work than the passive strategies that flourished when growth was more evenly distributed. It also requires an openness to explore non-traditional channels to uncover opportunities that other investors – unable to move on from the days of ultra-low rates – will miss.
A recent JP Morgan Private Bank advertisement stated in bold letters: “Alternative investments have gone from exotic to essential.” Private market investments, whether equity, debt, or real estate, represent a new vein of opportunity for investors, presenting the possibility of alpha in a declining market.
There is no shortcut or ‘easy button’ to acquire these returns, but aligning yourself with an experienced team can provide you with the required advantage in aiming for these returns.
[1] Wall Street Journal
[2] Mckinsey & Company
[3] Euromonitor
[4] Barrons
[5] Goldman Sachs