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The Federal Reserve last met on June 11-12 when, as was widely expected, they opted to hold rates steady pending more conclusive data that inflation was under control. The Fed also published its updated economic projections, which showed that it only expected to make one rate cut this year (a reduction from three expected cuts in the previous release).

The published materials included an updated version of the ‘dot plot’ - a graph that shows the variation in views in the committee - with some members predicting no cuts and others predicting as many as two before year end.

 The subsequent statements by individuals on the committee reflected this divide, with some indicating they felt the momentum was positive, while one member retained the possibility of raising rates even higher.

The end-June release of the Personal Consumption Expenditures Price Index (PCE) inflation data showed both the core and headline numbers trending downwards, which was welcome news.

The real stir, however, was caused by the latest Consumer Price Index (CPI) inflation figures published on July 11. These not only came in lower than expected, cooling for the 3rd month in a row, but also saw prices actually fall month-on-month by the largest amount since 2020.

This means that inflation has for the moment been replaced by deflation - a psychologically significant moment.

The detail beneath the headline figures shows that while many prices - such as food, rent, and healthcare - are still at a higher level than before the onset of COVID-19, rental and home-related costs are rising at the lowest rate in 3 years. As rental is normally the last category to slow down, this has been taken by some as a sign that the tide is finally turning.

On July 10, Federal Reserve Chairman Jerome Powell delivered his semiannual testimony to the U.S. Congress. He made several remarks in his formal statement and the following Q&A that seemed to confirm not only a change in sentiment at the Fed, but also in focus.

In asserting that the economy is ‘more or less back’ to its pre-pandemic levels, Chairman Powell came closer than ever to declaring the battle against inflation won. However, he went on to say that the central bank should also be keeping an eye on its other mandate to maintain employment levels. In other words, holding rates too high for too long could damage the economy for no good reason.

Comments by other members have underscored that the mood is changing to how quickly, rather than whether, to cut rates.

 Meanwhile, the markets are confident that the September meeting will see the first of a series of cuts that many appear to believe will continue well into next year.

Zooming out, we can see that even before the positive CPI figures sparked a new wave of optimism, broader concerns were already pointing to lower rates.

 earlier in July highlighted the challenge posed by the U.S. national debt, which is growing faster than the U.S. economy. Higher interest rates contribute in no small part to making this problem worse.

As investors, it is these broader issues that should concern us. It is tempting to get caught up in the exuberant gyrations of a market that may believe that the ‘good old days’ of ultra-low interest rates are returning.

Instead, it could be wiser to take a more balanced view that assesses the new challenges that could arise as a result of lower rates in a world that has fundamentally shifted since the pre-pandemic era (see our white paper 

In a market as interconnected as today’s world, there is no such thing as completely ‘good’ news, but there is such a thing as good analysis.

A Potential Shift for the Fed? The Details Beneath the Optimism

A Potential Shift for the Fed? The detail beneath the optimism

While many continue to hope against hope for a return to ultra-low interest rates, as inflation persists across developed economies, this hope seems increasingly remote. Since the end of last year, many leading institutions have been speculating about a new era of higher inflation and, as a result, higher rates.

Higher borrowing costs mean, at a very basic level, that companies need to make money in order to survive, let alone provide a healthy return to their shareholders. All other things being equal, this means lower shareholder returns overall.

What are the potential countervailing factors?

Governments are facing high levels of debt and are unlikely to be able to prop up their economies with stimulus spending, as was common in the onset and immediate aftermath of the pandemic.

So, in the face of higher costs - materials, labor, and capital - and without generous government support, something else will be needed in order to avoid an era of stagnation.

The 1990s present an interesting reference point for our current dilemma. While seen in retrospect as a golden age for the US economy, both inflation and interest rates remained ‘high’ throughout the decade, averaging 3% and 5% respectively - similar to today’s levels.

What, therefore, was behind the boom? There is a general consensus that improvement in 

, thanks mainly to private sector investment in technology, played a large role in driving economic growth.

The wider adoption of computer hardware (PCs) and software (Windows, Microsoft Office), together with the early growth of the internet, made it possible for companies to utilize their workforces more effectively, and so improve the bottom line.

This would have been hard to predict at the beginning of the decade when growth was sluggish and the economic outlook appeared grim. Could we see a similar story unfold in the latter half of the present decade?

There are two rays of hope for the productivity outlook, which could drive a repeat of the 1990s boom.

The first is, in a sense, already much discussed: the proliferation of automation (for manual labor) and increasingly AI (for cognitive labor) could have as great or an even greater effect on the ability of companies in sectors such as healthcare to achieve higher output for lower costs, thus neutralizing the effects of inflation and a potentially higher tax burden.

Focusing specifically on the role of generative AI, we see its potential to revolutionize industries by automating complex processes, generating new content, and enhancing decision-making. Generative AI can assist in creative tasks such as content creation, design, and even strategic planning, providing businesses with tools to innovate at a pace previously unimaginable. By leveraging generative AI, companies can not only streamline operations but also unlock new avenues for growth and efficiency, making it a cornerstone of the next productivity boom.

The second is not only less discussed but - in our view - framed incorrectly as a challenge rather than an opportunity: the ‘aging population’. The received view is that older members of society will exert a net negative effect on economic growth, and that longer life expectancy will serve only to make the problem worse.

This, however, is based on the assumption that older workers exit the workforce at the standard retirement age and cease all economic activity. The reality - only recently winning recognition - is that older members of society are not only willing to continue to work but are also uniquely positioned to contribute in a knowledge-based economy.

We are therefore not seeing an ageing crisis, but a longevity windfall.

The labor participation rate of older workers is already increasing, and advances in technology in particular AI will - arguably - make the wisdom that comes from experience more valuable, as more mechanistic skills are replaced by faster-automated alternatives.

When forecasts fail, they very often do so owing to assumptions about the future that are based on the past. In the 1970s, claims that we had reached ‘peak oil’ were based on the incorrect view that no further significant reserves would be found and that extraction procedures would not continue to develop.

Similarly, there are rich seams of opportunity - perhaps hidden to many - in the global economic landscape. Looking back at the history of human innovation, an optimistic attitude seems to be a rational choice.

Why the future may be brighter than many are predicting

From an investor perspective, investing in public companies has traditionally been seen as safer than investing in private firms. On the face of it, this still makes sense. A company must achieve a certain amount of success to be eligible for an IPO, and once public, it is subject to a greater degree of transparency than private firms, meaning that investors can monitor performance more easily.

Investing in public companies has also been highly profitable. The S&P 500, for instance, is currently enjoying a near decade-and-a-half bull run. Looking back further, the US stock market has delivered superb long-term returns to investors who have stayed the course in the past 50 years.

The shifting balance of private vs. public

One major change in the landscape is the number of companies deciding to either remain private for longer, or even ‘de-list’ (go from public to private). The result has been a steady decline in the number of public companies overall.

The total number of public companies traded on US exchanges, for instance, peaked in 1996 (8,000+) and has since more than halved to 3,618.

 Globally, 75% of the world’s highest-earning companies ($1bn+ in revenues) are now private.

, going private has a number of advantages for companies themselves, as well as for their investors. These benefits include greater control, less exposure to market volatility and short-term expectations, and a lower regulatory burden.

The main benefit, however, is that keeping a company private for longer means that it is possible to capture more of the returns that come from its growth during the period.

The relatively new phenomenon of ‘unicorns’ (private companies worth over $1bn) is an illustration of this, with most such companies - including Uber and Airbnb - waiting around a decade before going public, if at all.

The rapid rise of so-called ‘private markets’ as a counterpart to the public markets is a growing phenomenon.

 The growth of funds that gather capital and deploy it to private companies in the form of debt or equity has meant that such firms have a robust - and expanding - list of options for financing.

Investors with an eye on the uncertain future of public market returns in an age of higher inflation and higher interest rates (see our 

 white paper) can also expect higher returns for a comparable level of risk. As Apollo Global Management CEO Marc Rowan pointed out in a recent talk, private companies are not necessarily riskier investments than public companies - the difference ultimately is about liquidity.

Investors in public markets essentially pay a ‘liquidity premium’ for the fact that they can buy and sell investments easily. Private market deals are typically illiquid, with time horizons of 7-10 years. But as Rowan points out, for a long-term investor, such as a person saving for retirement, illiquidity is not a problem, and liquidity is therefore not worth paying for.

Studies have shown that private debt instruments of similar risk can yield 60-90 bps more than public equivalents, simply owing to the difference in liquidity.

 This spread can of course be far higher for individual deals. When it comes to private equity, the liquidity spread can be higher still, with Barclays estimating a premium of between 2% - 5%.

Many have observed that public markets are increasingly dependent on a small number of technology stocks - such as Apple, Nvidia, and Microsoft - to deliver continued growth.

 The current level of concentration - with 35% of the market concentrated in the top ten stocks - is at a historic high, it's important to recognize that this trend is specific to certain markets.

Given the above, it is worth reconsidering whether the perception of public markets as ‘safe’ and private markets as ‘risky’ has stood the test of time. If the ground has shifted in the past two decades, investors would be well advised to adjust their strategies, accordingly, considering a more holistic view of global market opportunities.

The Dynamics Of Market Emotions

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