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Is the era of easy money coming to an end?
David Hoag
Darrell Spence
Diana Wagner
April 21, 2022
With interest rates trending downward for more than 40 years, investors enjoyed a powerful tailwind driving one of the greatest bull markets in history. But what happens when rates suddenly start moving up as inflation soars to levels not seen since the 1980s? We’re about to find out.
Now that the U.S. Federal Reserve and many other central banks around the world have committed to hiking rates and cutting stimulus measures, investors face an important question: Is the era of easy money coming to an end? As usual in the financial markets, the answer isn’t a simple yes or no.
“It's probably the end of free money, but I don't think it's the end of easy money,” says David Hoag, a keen Fed watcher and portfolio manager “Central banks will do what they need to do to get inflation under control, but I don’t think they will be able to go too far before the real economy starts hurting.”
Free fall: Interest rates have plummeted in the era of easy money
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Sources: Federal Reserve, Refinitiv Datastream. As of 4/11/22.
The Fed, for instance, isn’t likely to raise the federal funds target rate anywhere near the long-term historical average of just under 5.0%, Hoag notes. The Fed’s key policy rate — which guides overnight lending among U.S. banks and influences many other forms of borrowing — currently sits in a range between 0.25% and 0.50% following last month’s rate hike.
Hoag thinks the Fed will stop hiking somewhere around 2.0%. “That’s a significant increase from where we are today,” he acknowledges, “but it’s still very low on a historical basis. Anything higher than that, in my view, risks pushing the U.S. into a recession.”
At the moment, market expectations are higher, thanks to hawkish comments from Fed officials over the past few weeks. The futures market is pricing in a rate of 3.0% by March 2023, including a 50 basis point hike at the Fed’s next two-day meeting beginning 3 May.
Fed rate hike expectations have risen dramatically
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Sources: Capital Group, Chicago Mercantile Exchange. Federal funds target path based on probability analysis of fed fund futures contract prices as calculated by the Chicago Mercantile Exchange. As of April 14, 2022.
Over the past 14 years, the Fed has taken the previously unprecedented step of slashing its key policy rate to near zero — first as a reaction to the 2007–2009 global financial crisis and then to help support the U.S. economy during the COVID-19 crisis. Massive bond-buying stimulus programmes also served to keep longer term interest rates artificially low.
“You can’t keep money at zero interest rates forever,” says Capital Group economist Darrell Spence. “We are seeing the end of this current period of zero rates and balance sheet expansion, but I’m not convinced that we won’t be back here again.”
Pushing the “easy button”
The Fed, European Central Bank and other central banks have found the “easy button” when it comes to addressing periods of severe financial crisis, Spence explains, and it would be naïve to think they won’t use it when the next crisis comes along.
“I’m sure history will look back at this period and find many reasons to argue that it was a bad idea,” he adds. “But, in the moment, it’s difficult to say what else we could have done or what we might do differently in the future. When you let the genie out of the bottle on this type of monetary policy, it’s hard to put it back in.”
In the meantime, investors should brace for further volatility as high inflation, tighter monetary policy and the war in Ukraine continue to disrupt markets. Recession risk is higher in Europe, Spence says, because of its closer proximity to the war and dependence on Russian energy, but the U.S. economy is also slowing under the weight of broken supply chains and higher consumer prices.
Spence doesn’t think a U.S. recession is imminent, but he puts the chance of an economic downturn at 25% to 30% by 2023, particularly if the Fed follows through with a full complement of rate hikes between now and then.
What does an environment of low growth and rising rates mean for investing?
Consider building an “all weather” portfolio
Despite investor fears of tighter monetary policy, U.S. stocks and bonds have powered through previous periods of rising interest rates. During 10 such periods since 1964, the S&P 500 has posted an average return of 7.7%. Bonds have also held up well, with the Bloomberg Barclays U.S. Aggregate Index returning an average of 3.9% during seven rate hiking cycles dating back to 1983.
The initial adjustment period can be tough, as we saw in the first quarter of this year, with the S&P 500 down 4.6%. Bonds suffered their worst quarter in 20 years, with a 5.9% decline. But over longer time periods, markets have tended to adjust, and bond investors in particular have benefited from the opportunity to reinvest at higher yields.
U.S. stocks generally have done well during past rising rate periods
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Sources: Capital Group, Refinitiv Datastream, Standard & Poor's, U.S. Federal Reserve. S&P 500 returns represent annualized total returns.
Of course, this data comes with the usual caveat that past results are not predictive of future returns. And, in fact, we’ve never experienced a period where central banks are unwinding massive balance sheets — much larger than they were following the global financial crisis — while raising interest rates from zero (or even negative territory in the case of the ECB). A lot can go wrong.
Such uncertainty makes building an “all weather” portfolio all the more important, says portfolio manager Diana Wagner.
For active investors, the key to navigating difficult periods is finding attractively valued companies that can generate earnings and profit growth regardless of the economic environment, Wagner explains.
“In this environment, there's going to be less tolerance for business models that can’t demonstrate a path to profitability in some reasonable time frame,” she says. That’s in contrast to last year when unprofitable tech companies rallied.
That doesn’t mean tech stocks can’t do well. In fact, the information technology sector has generated solid returns during the last four periods of rising rates. But it’s important to be selective.
Which sectors have performed best when interest rates rise?
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Sources: Capital Group, Refinitiv Datastream, S&P 500. Rate hike reference periods include February 1994–February 1995, June 1999–May 2000, June 2004–June 2006, and December 2015–December 2018. Average return calculations are based on annualized total returns.
Wagner cites Microsoft, UnitedHealth and Marsh & McLennan as examples that have exhibited “all weather” capabilities in the past.
“In a market where growth may be scarce,” she adds, “I prefer companies that have a demonstrated track record of making their own growth happen — companies with high return on equity, low commodity input costs and strong pricing power.”
Moreover, valuations are paramount.
“I think the era of not paying attention to valuations is gone,” Wagner says.
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