Rising global interest rates are currently the most important macroeconomic factor influencing financial markets. Since bottoming out at 0.55% in July 2020, the widely followed 10-year U.S. Treasury bond yield has steadily risen to a current level of 4.75%. In the United States, the Federal Funds Rate has increased from near zero in early 2022 to a current level of 5.33%. In less than two years, the Federal Reserve has increased this overnight lending rate a total of 11 times.
This aggressive shift in monetary policy has put an end to 14 years of “free money”. This policy was put in place following the financial crisis in 2008-2009, as central banks kept rates at artificially low levels in order to support the global economy. While successful, the growth level achieved by these actions was modest, and when combined with government support during the pandemic, ultimately led to the high levels of inflation experienced over the past couple of years. This recent tide of inflation, if left unchecked, would introduce a new level of complexity to the economic environment and act as a potentially long-term restraint on underlying growth. As such, central banks have reacted appropriately, tightening the money supply, and raising rates to current levels. Furthermore, they have signaled that these elevated rates will be sustained for the foreseeable future.
The return to a historically “normal” interest rate level will result in a healthier economy over time, where capital is more prudently allocated, and market forces are able to play a larger role in balancing the trade-off between risk and reward. Free money has unfairly elevated the value of higher risk assets, driven the price of home ownership out of reach for many, and led to greater wealth inequality. Free money has also encouraged excessive levels of borrowing by both individuals and governments. For example, over the last five years, the U.S. federal government debt alone has increased 56% to almost US$34 trillion.
With interest rates likely to be higher for longer, this in turn elevates the cost of capital for both short- and long-term investment decisions. Governments will have to be more responsible, as will individuals. Although North American unemployment rates remain near multi-decade lows and personal balance sheets overall remain quite healthy, consumer spending does drive roughly two-thirds of GDP activity and as such, the financial health of individuals must be monitored closely. Ultimately, higher rates will begin to slow down the economy by design, the question that remains is whether it will be enough to tip it into recession.
From a corporate perspective, we favour investing in companies with strong balance sheets, leading market positions and a track record of successful cost management. Companies that are built to succeed in an era of both a higher cost of capital and a softer economic environment will yield the best returns for investors. These are the types of companies that will continue to form the basis of your portfolio.