In November, Federal Reserve Chairman Jerome Powell publicly announced that we are in an economic environment characterized by lower interest rates, lower growth and lower inflation. To the surprise of many, he branded this environment a “new normal,” suggesting that it may be permanent. What makes this announcement so striking is that, a little over a year ago, the Federal Reserve was aggressively raising rates—an action generally deployed to mitigate inflation in an overheating economy. So, what happened to cause the change in outlook and, more importantly, where are we headed from here?
The Federal Reserve was likely interested in achieving two things by raising rates. For one, the economy was growing on the back of corporate tax-stimulus, so keeping inflation in check was clearly a motivation. Second, the Federal Reserve was interested in raising the benchmark rate above zero so that it would have some ability to stimulate the economy (i.e., lower rates) when needed. The Federal Reserve had taken a gradual approach with one increase in 2015 and 2016 before accelerating in 2017 with three increases, followed by another four in 2018. Then in early 2019 the rate-increasing actions abruptly stopped with Powell citing subdued inflation as a key driver.
Hindsight is 20/20 but, in retrospect, the Federal Reserve’s aggressive rate raises in 2018 appear to have been a mistake. The Reserve was raising rates at a time when the following was also true: (1) aggregate international GDP growth was slowing, (2) many international federal banks were lowering rates, and (3) the Federal Reserve was also removing stimulus by reducing its balance sheet. The combination of these factors proved too onerous for the US equity market and the fourth quarter of 2018 saw a dramatic downward spike in equity prices. Investors were clearly unhappy with the actions of the Federal Reserve. Bear in mind, it’s not the Federal Reserve’s job to stabilize the stock market, but Powell did reference “stock market volatility” as a consideration in his rationale for pausing in early 2019. It’s clear that they would like to avoid being a cause of instability. It’s easy to assess why the stock market doesn’t like higher rates. They mean higher operating costs for businesses that borrow money (i.e., a higher cost-of-capital). Moreover, in a rising-rate environment, highly-leveraged businesses face refinancing risks. In other words, some of these businesses could be pushed into bankruptcy when replacing lower-cost debt at maturity with higher-cost debt.
Where do we go from here? At this point, we agree with the “new normal” thesis. Interest rates and inflation are generally just by-products of growth levels. When growth is high, inflation tends to also climb and, in response, federal banks increase rates. If you want to project interest rates, you first need to project growth. And, unfortunately, US GDP growth coming out of the Great Recession has been tepid. While the current “recovery” is the longest on record, the average annual GDP growth rate of around 2% is among the lowest. In fact, if you look at the long-term trend in US GDP growth, it’s clearly downward. On the bright side, the US is normal in this regard among its developed-market peers. In developed-markets, the GDP growth rates, along with inflation and interest rates, are unmistakably downward trending over a long period of time. Most economists tend to agree that the downward pressure stems from demographics (i.e., an aging population that spends less money) and economic changes (e.g., moving from a manufacturing to a service-based economy).
Perhaps the best example of a “new normal” is Japan—a country that has struggled with low growth, low inflation and near-zero interest rates for several decades. The United States, along with other developed-nations like Germany, France and the UK, have demographic trends that lag Japan’s but tend to be very similar. So, perhaps Japan is a good leading indicator for where we are all headed.
Lastly, it’s noteworthy that the stock market may not be able to handle higher rates. Corporate leverage is at all-time highs and raising rates may, quite simply, push many companies into insolvency.
The “new normal” environment will have significant investing implications. A perpetually low-rate environment will be beneficial to many corporations—especially those in capital-intensive businesses like REITs. Many companies have been taking advantage of lower rates to both reduce their overall cost-of-capital and extend maturity on debt so that they can enjoy low rates for longer. Many of these businesses, in fact, enjoy the lowest financing costs in their history. Low rates are generally good news for corporations.
However, the low overall GDP growth projections will prove to be a headwind. Gains in stock market prices will likely come more slowly as many studies have shown a clear connection between overall GDP growth and equity market capitalization growth. The low-rate environment will likely be the most challenging to older investors who seek to reduce stock-market exposure in favor of more stable “fixed-income” investments. At present, we’re facing a paltry yield on these types of investments (e.g., long-term investment grade bonds are only paying 3-4% interest/year) and long-term US Treasury bonds are paying under 2.5%. These are frighteningly low figures if one believes they are not expected to rise anytime soon (if ever). Moreover, given that we seem to be in the later stages of the economic cycle, this would be considered a bad time to “reach for yield” (i.e., invest in riskier high-yield bonds or high-risk credit instruments).