Economic conditions are beginning to look more normal than they have in years – but that doesn’t mean investors should be complacent. Just the opposite, in fact.
After a decade of being supported by some of the lowest interest rates in recorded history, stock prices are now facing headwinds as borrowing costs ratchet back to more customary levels. The inevitable result is volatility. Whether the topic is General Electric’s future or the embattled tech sector, investors are redoing their calculations of value based on the assumption that interest rates in North America have nowhere to go but up.
For anyone who owns stocks, the trend toward what central bankers call rate “normalization” raises a horde of interesting questions. For starters, just how close are we to normal anyway? How much longer are the rate hikes likely to continue? And who is going to feel the pain the most?
The short answers, for now, are that we’re still a taxi ride away from normal and that this rate-rising cycle could go on for far longer than you might like. Hardest hit will be heavily indebted companies (yes, GE, that’s you we’re talking about). Also vulnerable will be tech companies that derive much of their value from projected profits that aren’t expected to materialize for many years to come. Higher interest rates will shrink the present value of these companies’ future earnings.
To be sure, all these prognostications are based on the notion that rates will eventually return to where they have historically stood in real terms. Right now, despite steady hikes over the past year, monetary policy still looks strikingly easy when compared to earlier decades.
Consider the Fed funds rate, the world’s most watched indicator of monetary policy. The U.S. Federal Reserve sets this measure of what U.S. banks charge each other for unsecured overnight loans and only recently raised it north of 2 per cent. With inflation running also running around 2 per cent, the real Fed funds rate – the cost of borrowing after accounting for the impact of inflation – sits close to zero.
This is distinctly unusual. Over the past half century, the real Fed funds rate has usually been one to four percentage points above zero when the U.S. economy is not in recession. If past is prologue, U.S. monetary policy could go on tightening at regular intervals for a couple of years.
A similar situation holds true in Canada, where the Bank of Canada’s policy rate stands at 1.75 per cent. Meanwhile, inflation, by the Bank’s preferred indicators, is running around 2 per cent. The real policy rate is therefore negative, and would have to rise substantially to return to the range it has inhabited in previous decades.
Could this time around be different? It’s possible that technology and globalization have shifted economic fundamentals in a way that reduces the risk of inflation and also the real borrowing costs needed to keep inflation in check. The overriding goal of much modern monetary policy is to achieve steady, low inflation around 2 per cent. By that standard, today’s low, low borrowing costs are exactly where they should be.
But policy-makers who focus solely on inflation may be missing a key part of the picture. Low rates breed problems of their own, notably increases in debt and surges in asset prices driven by the availability of cheap loans.
Canadians have borrowed heavily over the past decade to buy homes. Even a modest upswing in mortgage costs could turn into a major drag on household spending. Similarly, companies in both Canada and the United States have gone on a borrowing binge. The rush to lever up has helped drive stock prices higher but also increased corporate vulnerability to higher borrowing costs.
The Bank for International Settlements warned this summer of “the continuous deterioration of non-financial corporate balance sheets” across much of the developed world. It noted that corporate leverage in the United States, in particular, is at its highest level since the turn of the century and similar to that prevailing after the leveraged buyout boom of the late 1980s. An unusually large swathe of companies are now barely clinging to investment-grade credit ratings, while commercial property prices look vulnerable to any sustained rise in interest rates.
The risks are real – but so are the positives. Stephen Poloz, Governor of the Bank of Canada, said last week that higher bond yields and more volatile stock markets are “welcome symptoms of normalization.” He argued that ultralow rates are disappearing simply because a stronger economy means they are no longer necessary.
He is no doubt right. But the process of getting back to normal is likely to involve more drama than most investors would like. If you’ve found recent stock market fluctuations to be too stressful for your liking, this is an excellent time to reduce your exposure to heavily indebted, tech-focused companies.
Ian McGugan