Investment Strategies

OPINION OF THE WEEK: Rates Aren't Dropping To Pre-Pandemic Levels – And That's Good

Tom Burroughes Group Editor 25 June 2024

OPINION OF THE WEEK: Rates Aren't Dropping To Pre-Pandemic Levels – And That's Good

For a whole range of reasons, going back to the rate levels that existed before the Covid calamity of early 2020 will be unlikely and, in the view of the editor, would be a mistake.

A world where interest rates stay relatively higher and for longer than some might hope means that companies must work harder to attract capital. This also plays to the strengths of active fund managers and highlights the benefits of undertaking deep research into companies.

This is the view from Ali Dibadj, chief executive, and Matt Peron, global head of solutions, at the Anglo-US investment house Janus Henderson. And when you think it through briefly, none of these conclusions ought to be surprising. And perhaps at the risk of incurring the wrath of those who yearn for rates being where they were before the pandemic, I think this state of affairs is healthy. 

A book that came out in 2022, The Price Of Time: The Real Story of Interest, by Edward Chancellor, brilliantly held up reams of examples of how feckless governments and banks down the centuries offered interest on loans at below market rates. There were bubbles and busts in the former European colonies of North and South America; the tulip mania in Holland; railway boom in 1840s Britain; radio sector blow-out in the 1920s; the 1990s dotcom boom – and bust, and the sub-prime mortgage calamity of 2008. (Those of a nervous disposition about US chipmaker titan Nvidia’s spectacular share price gains should look away now.)

There is a lot of commentary that rates have peaked and should head lower. Even the UK’s Institute of Economic Affairs, a hard-headed advocate of free markets, chided the Bank of England last week for holding fire on its key rate – at 5.25 per cent – after tame inflation figures. 

And there has already been movement: The Swiss National Bank cut its key rate by 25 basis points to 1.25 per cent last week. Earlier in June, the European Central Bank cut its lending rate by 25 bps to 3.75 per cent – the first time it had cut rates for five years. The US Federal Reserve – the most consequential central bank of the lot – recently left the fed funds target range steady at 5.25 per cent to 5.50 per cent for a seventh straight meeting in June, but the sense still seems to be that the Fed will cut this year.

I like to think that, beyond the inflation targeting approach that central banks have used for almost three decades, awareness may be creeping back in that it is not just consumer price inflation that ought to be a yardstick for policy. It also matters how rates, when held below a market rate (the level at which real savings demand matches supply) can distort the capital structure of an economy.

Artificially low rates push up asset prices, which benefits those who already own assets such as commercial and residential property, equities, forms of debt, etc, but hurts those reliant on a fixed income, or who haven’t yet got near to acquiring assets. Much of the angst about wealth inequality that drives the angry populist movements in the West can be pinned on this effect. 

Very low rates also produce corporate “zombies” – why bother to improve business over the medium term with better products and services when you can keep the machine staggering along on an empty-carb diet of cheap money? And cheap borrowing encourages CEOs to buy back stock to boost return on equity – and the value of their stock options – and never mind the long-term results. Debt leverage and other forms of financial engineering become all the rage, and boring stuff such as R&D falls out of fashion. A result is weaker growth, slack productivity, and stagnant wages.

It may seem like a form of “tough love,” akin to adopting weight training, taking ice baths or intense cardio workouts, but a longer period of keeping rates close to where they are might be just what mature economies need. The focus must be on companies earning the willingness of lenders to provide capital. That means more focus on earnings' visibility and pricing power. Bloated HR departments and non-core initiatives are harder to justify if it is at the cost of serious innovation and sales growth. 

Such an environment also means, perhaps, that the asset management sector will have more reason to use its muscle in focusing boardrooms on driving sustainable (in the broadest sense) returns.

Active fund management can take a back seat when markets effortlessly rise on a sea of cheap credit, but it looks worth paying for when the easier times fade. So I expect big fund management houses to bang the drum a bit more about active management – which of course typically carries a higher fee than when holding shares in a large exchange-traded fund.

The aforementioned Janus Henderson managers already think the mathematics is starting to move in the active fund management school’s favour. “Based on data going back to 1990, the average passive fund outperformed the average active fund when the yield on the 10-year US Treasury Note was 3.50 per cent or lower. However, when yields are higher than 3.50 per cent, as we expect for the foreseeable future, the average active US equities fund has historically been ahead. Of course, this is based on the average active and passive fund, and active managers with proven research capabilities and strong track records would aim to beat the average.”

This news service has already chronicled a number of ways that this sort of “regime change” has affected the investment world. In the US, money market funds boomed as the rates rose. The spike in borrowing costs played a part in wrong-footing the likes of Silicon Valley Bank last year. On the other hand, Switzerland’s period of negative official rates, which ended after the pandemic, ended a time when lenders were squeezed severely, forcing depositors to pay a premium just for the privilege of having an account, and making them go up the risk curve to even stand still. I doubt anyone is in a rush to see those days come back.

Another, final change is one that I think is the most important of all. We have had to return to the idea that borrowing capital means you borrow a claim on resources that have alternative uses, and that doing so means paying a price. When capital is available for nothing, it bends an economy out of shape. Whatever cuts do eventually happen, I hope we don’t go back to the extraordinary low rates from 2008 to the pandemic.

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