Multi Asset Perspectives: The trouble with interest rates

GAM Investments’ Julian Howard outlines his latest multi asset views, exploring how, undeterred by the transatlantic banking crisis, policymakers’ focus on inflation and rates will hamper short-term market progress.

06 April 2023

Review

Global equities as measured by the MSCI AC World Index rose 7.2% in local currency terms in the first quarter. That such an outcome was achieved was surprising given the banking problems that unfolded in March. A combination of fast-rising interest rates, poor risk management and a social media-fuelled run on deposits sealed the fates of Silicon Valley Bank and Signature Bank, while raising questions about the integrity of the US regional banking industry. Arguably even more dramatic was the hastily arranged takeover of Swiss banking stalwart Credit Suisse by arch-rival UBS as confidence started to drain on both sides of the the Atlantic and investors and depositors looked to exit weaker institutions.

Stock markets and bond yields both fell sharply in response, before recovering somewhat. Up to this point equities had in fact been enjoying a firm run dating back to October 2022 when elevated US inflation first started to decelerate. Easing global supply pressures and pronounced disinflation in goods prices around the world continued into the first quarter and, while labour market data in the US suggested that the process was not going to be smoothly linear (an unrealistic assumption anyway), US headline CPI was generally heading in the right direction, falling from its mid-2022 peak of 9% to 6% at the latest reading. But this was not fast enough for the major central banks. In March alone, the US Federal Reserve (Fed), European Central Bank (ECB) and Bank of England raised rates by 25 bps, 50 bps, and 25 bps, respectively, citing confidence in the post-2008 supervisory framework to deal with systemic banking risks while they focused on inflation.

In the background, the growth outlook continued to quietly improve. At the beginning of the year Bloomberg’s survey of economists’ US GDP growth expectations for 2023 had started out at a fairly dismal 0.3%, but by the end of March those estimates had risen to 1% thanks in large part to a resilient consumer. China’s re-opening also helped vanquish the recession demons despite some bemoaning the apparently unambitious 5% 2023 growth target set by the National People’s Congress. The banking issues, therefore, only partly clouded the relatively benign conditions of firmer growth and gradual disinflation (in the US at least) that underpinned the first quarter. Equity investors appeared comfortable enough with the decisive actions taken by regulators to be able to focus on these slightly better fundamentals for the time being, even if broader questions about the economic and regulatory impact of the banking crisis and the continued inflation and rates conundrum remained outstanding.

Figure 1: Economic growth prospects for 2023 started to look up in the first quarter:

Outlook

At the time of writing, the full implications of the March banking difficulties and associated response have yet to make themselves apparent. Increased supervision, a higher cost of capital for financial institutions and tighter lending standards into the real economy are reasonable assumptions to make in this regard. On the latter point, five research papers published between 1992 to 2021 suggest banking crises have a negative GDP impact of anywhere between -1% to -10%¹. Regardless, it seems unlikely that the major central banks will reverse their current monetary policy tightening cycles to deal with individual instances of poorly managed banks. This would amount to an admission of the futility of monetary policy itself in dealing with inflation and explains why, as mentioned, the ECB in particular raised rates by 50 bps even as the crisis flared in mid-March, confident in its ability to deal with both the financial system and inflation separately and simultaneously.

So barring a major contagion event, the bigger issue facing the US and, therefore to an extent, the global economy remains the pathway of inflation and the associated interest rate response into the rest of the year and beyond. In our view, disinflation is well underway in the US, but we would note that the Fed remains institutionally traumatised by past instances of underestimation, not least that of 1980. In the spring of that year, inflation came down from high levels and the central bank eagerly cut interest rates only to have to belatedly tighten them again as prices unexpectedly spiked. Until the Fed declares the current disinflation sustainable and is prepared to start wrapping up the current monetary policy hiking cycle, it seems unlikely that stock markets will be able to gain significant traction from here given the relatively modest additional earnings yield advantage they now offer over risk-free interest rates.

Long term though, lower rates seem all but inevitable given the profound forces of secular stagnation which will conspire to keep growth, inflation and rates down. These include, inter alia, stubborn inequality, deteriorating demographics, the growing socio-political ambivalence towards private enterprise and, of course, climate change. In our view the best way to reconcile this long-term outlook with the need to weather near-term uncertainties such as banking issues, unclear interest rate trajectories and even turbulent geopolitics, is via a structural allocation to stocks diversified by a real-world, proven capital preservation sleeve. Our sense is that this combination will be tested again before too long.