For three decades, we have been trained to think that investing in fixed income markets is safer than equity markets. Should we throw that out the window, as interest rates keep rising with no signs of coming back down anytime soon? As fixed income markets head into a third consecutive year of losses, investors should assess what the fallouts from higher for longer interest rates are likely to be.
The original version of this article first appeared in The Business Times.
Let’s start with the facts — we cannot predict the future, and we are not likely to get the trajectory of where interest rates are headed right. 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 coming into this year. They were all wrong; not one of them got it right.
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 such as, “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.
The bond market appears to be more volatile than the stock market these days, and 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 year-to-date with double digit positive returns. On the other hand, fixed income markets, represented by the Bloomberg Global Aggregate index, are currently giving negative returns for the third consecutive year running. There was an unprecedented double digit fall in 2022 and it was sandwiched by two small losses in 2021 and 2023 year-to-date.
That is a painful thing to look at when, like me, you’ve grown up for three decades being told that bonds and fixed income markets would be a safer place to hide in times of trouble in the stock market.
One of the major reasons why fixed income allocation was so attractive was for this reason. However, is the thirty-year bull market in fixed income well and truly over? Unless it turns around by year-end (and we cannot rule out the possibility that this might still happen), bonds falling for three consecutive years will be a new record. They have fallen for two consecutive years a few times in history before, but a third consecutive fall has never happened in the history of the index.
Are we set for an unprecedented third year of fixed income market decline?
Source: Bloomberg, Endowus Research
Of course, a lot of it is driven by the rise in global interest rates with the US Federal Reserve leading the charge, continuing their hikes with a very hawkish tone that is influencing the markets negatively. The second half and 2024 outlook has significantly deteriorated, reducing expectations that interest rates have peaked and may come down. Peaked, they may have, and even that we are uncertain — but they are 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 to Ukraine, but these were ostensibly cyclical risks that would dissipate over time and when the cycle turns.
The markets since then have learned that they may have been short-sighted (as usual) in overlooking some of the structural risks. By this, I mean 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 with the risks that were associated with the potential shutdown of government, due to the debt ceiling first, and later the fiscal budget not being passed. This was 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 higher rates. However, this is not just a US problem; the heavy indebtedness is relevant to 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, sharp volatile moves in even the safest treasuries markets, is the market 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 like fixed income, as we have recently learned. As Ernest Hemingway once said, “How do you go bankrupt? Gradually, then suddenly.”
Another concern that has been raised recently is the fact that there has been surprisingly and persistently stronger than expected growth in the economy. This has been one of the reasons cited for the persistently higher inflation — not just cost push, but demand pull. This has transpired despite repeated calls from experts that a recession is imminent or certain. We seem to have avoided a recession, despite the high interest rates and headwinds faced so far.
But wait a minute, I thought a strong economy was a good thing. Why then is the market reacting negatively? It may have to do with the fact that growth is what is stoking the 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 or interest rates; the Ukraine war or Chinese government policy. Uncertainty requires that I am 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 interest rate environment when cash is paying you a 4% risk free (although US government bonds are not without risk, as we are finding out), there is a higher bar for investors to clear to invest in any assets.
However, we must not lose sight of the forest by focusing on the tree. The stronger than expected growth is indeed the only silver lining to the dark clouds that encircle us. That there has been one clear constant of better-than-expected growth throughout the last three years, is a good thing — despite many protestations to the contrary. Economic growth has weathered through the storm relatively unscathed, and it is truly a testament to continued human advancement whether that is through technological innovation, greater productivity, or new discoveries like 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 for longer is normally the reason why economies go into recession. 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 their heavy debt. These are what financial crises and bankruptcies are made of; it comes gradually, then suddenly. So just when the markets are getting comfortable with the prospect that growth is strong and a recession is avoided, this may be the very moment that we face the biggest risk to the markets: growth slowing down dramatically and crisis in the weakest links to the global economy and financial systems.
So where will interest rates be in a year? It literally is anybody’s guess. Maybe it will be higher as inflation rages on, and growth continues to be hot, while supply of goods and services remain limited with a tight labour market. Maybe it will fall dramatically as growth slows and the Fed has done its job and inflation is tamed — or maybe it will all 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.
Samuel Rhee 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 pension - CPF and SRS. He is formerly the CEO & CIO of Morgan Stanley Investment Management in Asia.