MARKETS have been breathing a huge sigh of relief. After months of relentless interest rate rises last year, rates are finally poised to fall, and the expectation is for as many as six cuts this year alone.
We strongly agree that the US Federal Reserve can afford to start easing rates, but are doubtful that inflation would fall as dramatically as some are hoping. Nor do we believe that interest rates would return to the near-zero levels of the pre-Covid decade.
On the contrary, we believe that fundamental global shifts will put upward pressure on inflation in the coming decade. For the Fed to meet its 2 per cent inflation target, we think interest rates will have to stay higher for longer.
Higher inflation not as scary as it seems
High rates, however, are not necessarily an economic and market evil.
The 1990s and early 2000s had what we call “relevant inflation”, or inflation that leads to a better functioning economy. To contain this inflation, the Fed raised interest rates to an average of about 5 per cent, but the economy continued to grow at a healthy rate.
Historical data tells us that higher interest rates can be a driver of economic resilience.
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When rates and inflationary pressures are high, and the economy is still growing, businesses and consumers are inclined to “spend now” before inflation erodes their spending power. This further boosts the economy and creates a “virtuous” circle. Higher interest rates also mean money is not “too easy”, and capital is therefore used more efficiently.
Disinflation not the answer
Similarly, disinflation or below-target inflation and low interest rates do not always boost economies. In the pre-Covid 2010s era, the Fed drove interest rates down to nearly zero in an attempt to counter disinflationary pressures. Growth, though, remained muted.
Japan offers a more sobering example of the dangers of ultra-low rates. Its disinflation cycle, which started in the 1990s, has led to stagnant economic growth and poor investor sentiment that have lasted decades.
As a result, someone who had invested in the Nikkei 225 from 2000 to 2020 would have seen average annual returns of just 1.8 per cent, not including dividends.
This is because, as opposed to high rates, low rates can create a “vicious” circle.
Central banks have the option to cut interest rates when their economies are deemed to be too sluggish, but once rates have been cut to zero or near zero, this option disappears.
At this point, consumers and businesses worry that a recession cannot be averted. They start to save rather than spend or invest, thus further depressing growth. This cycle of economic slowdown becomes impossible to break without radical action.
Inflationary pressures are becoming embedded
Having come perilously close to disinflation, the US and other global economies are more mindful than ever of the threat. In addition, 2023 brought a fresh revelation to central banks: despite the unprecedented pace and scale of Fed rate hikes, a recession has not materialised.
The Fed and other central banks would likely have become emboldened by this experience and more convinced that, on balance, it is better to risk rates being too high than too low. This is a timely strategy rethink given the potential for high inflationary pressures over the next decade.
Unlike in the immediate post-Covid years, these pressures are not temporary, but instead stem from deeply structural forces.
Having reaped the benefits of globalisation over many decades, the world is now facing its dismantling in the form of US-China tech wars, geopolitical tensions and “friendshoring” – trading primarily with ideologically friendly nations. Such trends, coupled with climate change, potential energy shocks and changing labour markets, spell higher business costs and consumer prices.
New strategies for a new era
Given the above, we do not expect US policy rates to return to the disinflation era of the 2010s. Instead, we think that, similar to the 1990s, rates over the next few years will range within a relatively tight band above the Fed’s 2 per cent target.
It is important to note that the 1990s era was not marked by poor investment returns. The S&P 500 returned above 10 per cent per annum and US Treasuries returned 6.3 per cent. Alternative assets such as global Reits and commodities also delivered strong performances of 13.2 per cent and 7.9 per cent, respectively.
Similarly, we believe a new higher-for-longer era can produce good investment returns. But investors will need to adjust their strategies accordingly. Going forward, we expect to see good performances from the following assets:
- Equities: Company earnings tend to grow in line with inflation, especially sectors such as energy, healthcare, IT and consumer staples that enjoy strong pricing power and inelastic demand.
- Real estate/Reits: Inflation is the devaluation of money, so when inflation rises, real asset prices follow suit. Higher building costs and rents also increase property values.
- Commodities: Like real estate, commodities such as industrial metals, energy and agriculture are real assets that hold their value amid currency devaluation.
- Longer-duration bonds: In a high-rate environment, the risks of holding longer-duration bonds are lessened. Investors may wish to choose longer-duration, higher-yielding bonds.
The writer is group chief investment officer, UOB Asset Management
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