The end of an era

The recent rise in long-term interest rates to the highest level seen in the last 17 years marks the end of an era. The period of low interest rates that prevailed after the Great Financial Crisis up until 2021 is now over, with implications for lending, the economy at large, and investment allocations.

The macro view:

In addition to their existing worries about inflation, financial markets are now also starting to show concern about fiscal developments. This is showing up at the long-end of yield curves, especially in the 7-10 years area, as investors demand higher interest rates due to rising risks.

• In the US, this rising risk narrative is being fuelled by discussion about the debt ceiling and the new budget, and uncertainty about when a new Speaker of the House of Representatives will be appointed, and who it will be, after Kevin McCarthy was voted out of the position.
• In Italy, the government’s decision to raise its 2023 and 2024 deficit projections caused some turmoil in financial markets, with 10-year yields rising. This showed “bond vigilantes” are back, ready to impose discipline on policymakers through higher yields.

The upshot of this rising risk backdrop and increased investor angst is – and will continue to be – higher funding costs for companies that need to tap the markets for financing. Typically, US companies refinancing their debt today in the high-yield segment need to pay about 9% interest – much higher than in previous years. In the mortgage-backed securities segment, or the commercial mortgage-backed market, the yields companies have to pay have increased threefold in the last 24 months.

For the economy, this means:

• Bank loan growth has slowed sharply, especially for businesses.
• Higher borrowing costs should create an economic slowdown towards the end of the year.

Impact on equities:

For equities, the background of rising fiscal concern and economic risk translated into a negative month in September and a compression in valuations, both in the US and Europe.

• The forthcoming earnings season will show whether, despite the challenging macro conditions, companies can continue to grow. If they can, that would mitigate the effect of higher rates on equity markets.

Investment themes:

We see three themes for the current environment:

1. Treating – and trading – volatility as an asset class. Various options strategies can be used to protect portfolios and monetise the uncertainty prevalent in financial markets today. These include equity hedges and capital-protected notes. We also believe rising yields present an interesting entry point to build exposure to US Treasuries and to sell Treasury volatility as we move closer to the end of monetary policy tightening.
2. Bond vigilantes. There has been a significant rise in US government bond yields in response to the US Treasury’s beefed-up issuance schedule designed to tackle the growing gap between government revenues and spending. Coupled with sticky core inflation, the higher yields suggest that bond vigilantes are back. In Europe too, they have made their mark: increased fiscal deficit targets in France and Italy met with a hike in long-term bond yields.
3. Diversified portfolios. With higher yields and equities markets under pressure, a diversified portfolio between bonds and equities makes sense. As we believe that interest rates are set to remain higher than in recent years for structural reasons, there is ample justification for high-quality government and corporate bonds to form a structurally larger part of asset allocations without any unnecessary increase in a portfolio’s risk exposure.