The financial markets are starting to get used to the idea that interest rates will be higher and for longer than had previously been estimated. This is crucial when it comes to constructing our portfolios for the medium and long term.
The explosion of the subprime mortgage crisis in 2008 forced central banks to cut official interest rates and invent a new form of intervention (we had never heard much about quantitative easing before that time). The balance sheets of the world’s ten major central banks then amounted to $5 trillion, which had been accumulated over centuries. This figure increased six-fold in just a few years, while interest rates stabilised at, if not below, floor level. No one in their right mind could have guessed that negative rates (i.e., having to pay to lend your money) would even be possible, let alone for such a long time.
In recent years, the norm in many developed countries has been zero interest rates, no inflation, and trigger-happy central banks ready to bail out the markets at the slightest hint of a problem. Many still see the rebound in inflation and rates as a passing phase until we go back to how things were, not too long now. However, it is worth remembering that as long as investors are human (artificial intelligence notwithstanding), our brains tend to extrapolate from the recent past to imagine the future. This is yet another cognitive bias that can distort the way we perceive reality and condition our investment process.
We will do very badly if we fail to understand that the next decade will be very different from the last. Inflation is highly likely to stabilise at levels well above the 2% that Powell and his colleagues are so hungry for. Many of the factors that held it back have been reversed. There are also massive fiscal deficits that can only get worse (politicians are unlikely to rein in spending on defence, green energy, or commitments to the ageing population), which add to the ever-increasing public debt. This always leads to inflation, helping to increase the debt denominator, which is measured based on GDP, if history is any guide.
This is crucial when it comes to selecting our investments. On the one hand, because our brains deceive us when we are tempted by the 3 or 4% coupon as a final solution. It is not likely to cover inflation, so it will seriously deteriorate the purchasing power of our savings over time. There is no choice but to take risks if we want to beat the price hikes. Yet, on the other hand, we must be more demanding than before with risky assets—there is no point in taking them on if they are not going to give us much more than a monetary fund. That is why we maintain a prudent position in our portfolios. It seems to us that, in general, we are underpaid for taking risk, and well paid for waiting for opportunities, which will come sooner or later. So, we will take the opportunity to extend the duration or take on credit risk, or increase equity exposure (all of the above with a bit of luck), which will allow us to build attractive future returns.
Published at Citywire 13.10.2023