LET us start with the facts: We cannot predict the future, and we are unlikely to get right the trajectory of where interest rates are headed. Anyone who says otherwise should take a hard look at the comments from various experts, and their interest rate forecasts from just two years ago and going into this year. They were all wrong.
What is important for investors to understand is the impact of higher interest rates and what this means for markets and investing generally. This goes beyond superficial statements the likes of: “When interest rates rise, bond prices fall, so it is negative.” I am referring to the second- and third-order effects of higher-for-longer interest rates.
Bond markets appear to be more volatile than stock markets these days. Recent numbers show this is not just a “feeling”. While equity markets corrected sharply in 2022, they were up in 2021 and are pretty strong in 2023 in the year to date, with double-digit positive returns.
On the other hand, fixed-income markets, as represented by the Bloomberg Global Aggregate index, are currently showing negative returns for the third consecutive year. There was an unprecedented double-digit fall in 2022, sandwiched by two small losses in 2021 and 2023 in the year to date.
That has been painful to watch if, like me, you have been told for the past three decades that bonds and fixed-income markets would be a safer place to hide in times of trouble in the stock market. After all, this was a major reason for the attractiveness of a fixed-income allocation.
But, is the 30-year bull market in fixed income well and truly over? Unless it turns around by year-end – we cannot rule out the possibility that this might still happen – bonds falling for three consecutive years would be a new record. While bonds have fallen for two consecutive years a few times in the past, a third consecutive fall has never happened in the history of the index.
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A new negative fixed-income record?
Are we set for an unprecedented third year of fixed-income market decline?
Of course, a lot of the decline is driven by the rise in global interest rates. The US Federal Reserve has led the charge, continuing their hikes with a hawkish tone that is influencing the markets negatively.
The 2024 outlook means that expectations that interest rates have peaked and may come down have dramatically fallen. Rates are definitely not coming down any time soon. There are several reasons and drivers for this.
Persistently higher inflation was the original thesis, and a well-supported one. Markets blamed everything from Covid-19 to China and Ukraine, but these were ostensibly cyclical risks that would dissipate over time when the cycle turns.
Markets have since learned that they may have been short-sighted (as usual) in overlooking some of the structural risks. By this, I refer to the structural problems of supply and demand in manufacturing, trade and labour markets.
On top of that, we now have systemic risk. The US is front and centre in this each time there is a threatened shutdown of its government, due first to the debt ceiling, and then the fiscal budget not being passed. This has been exacerbated by the downgrade of the US’ credit rating and concerns about the large increase in new debt issuance, as well as the higher cost of debt servicing due to the higher rates.
However, this is not just a US problem; heavy indebtedness is relevant for many nations and sectors from China and Japan to Europe.
Risks are plenty – cyclical, structural, systemic. For these reasons, the fixed-income market has been struggling, and these problems will not go away soon. Maybe the reason for the emergence of bond vigilantes, reflected in sharp volatile moves in even the safest Treasury markets, is that the market is pricing in these additional systematic and structural risks on top of the cyclical risks.
Things can change very quickly, even in a slow-moving market such as fixed income, as we have recently learned. As Ernest Hemingway once said, “How do you go bankrupt? Gradually, then suddenly.”
Another factor is the surprisingly and persistently stronger-than-expected economic growth. This has been a reason cited for persistently higher inflation — not just cost-push, but also demand-pull. We seem to have avoided a recession, despite the high interest rates and headwinds faced so far.
But if a strong economy is a good thing, why is the market reacting negatively? It may have to do with the fact that growth is stoking higher-for-longer inflation. More importantly, even growth is becoming increasingly difficult to predict. This has truly been a strange and unprecedented period of market volatility and maximum uncertainty about the future.
The market hates uncertainty, whether that stems from inflation, interest rates, the Ukraine war or Chinese government policy. Uncertainty requires that I be compensated over time to take on that uncertainty, through a heavier discount to the value of the asset I want to buy or own. In a high-rate environment, when cash is paying 4 per cent risk-free (although US government bonds are not without risk, as we are finding out), assets must clear a higher bar to attract investors.
However, we must not lose sight of the forest by focusing on the trees. Stronger-than-expected growth is indeed the only silver lining to the dark clouds overhead. Economic growth has weathered the storms of the last three years and appears relatively unscathed. This is a testament to continued human advancement, whether through technological innovation, greater productivity or new discoveries such as vaccines or artificial intelligence.
Therefore, growth is probably the single biggest risk to future returns for both equity and bond markets – for different reasons. Restrictive financial conditions, such as higher interest rates, are typically blamed for recessions. High US interest rates also lead to a strong US dollar. This sucks liquidity out from the periphery of emerging markets, and the weaker sectors of the market that cannot sustain the higher cost of financing and heavy debt burdens.
These factors influence the trajectory of financial crises and bankruptcies, which occurs gradually, then suddenly. Just when markets get comfortable with the prospect of strong growth is when the biggest risk arises in markets – that is, growth may slow dramatically and crises erupt in the weakest links in the global economy and financial systems.
Where will interest rates be in a year? It is literally anybody’s guess. Rates may be higher as inflation rages on and growth continues to be hot, while the supply of goods and services remains limited with a tight labour market. Or, they may fall dramatically as growth slows – the Fed has done its job and inflation is tamed. Or, rates may remain the same.
Perhaps the most important lesson of this year’s unpredictability is that in a growth-scarce environment, quality matters. Both quality growth in equities and higher-quality credit in the fixed income markets have performed relatively better and are likely to continue to do so, even if interest rates remain higher for longer.
The writer is co-founder and chief investment officer at Endowus, an independent wealth platform advising over S$6 billion in client assets across public, private markets and pensions (CPF and SRS)
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