of higher interest rates and scarcer capital
Prepare for impatient investors and pain in private markets—but also higher returns
Welcome to the end of cheap money. Share prices have been through worse, but only rarely have things been as bloody in so many asset markets at once. Investors find themselves in a new world and they need a new set of rules.
The pain has been intense. The s&p 500 index of leading American shares was down by almost a quarter at its lowest point this year, erasing more than $10trn in market value. Government bonds, usually a shelter from stocks, have been blasted: Treasuries are heading for their worst year since 1949. As of mid-October, a portfolio split 60/40 between American equities and Treasuries had fallen more than in any year since 1937. Meanwhile house prices are falling everywhere from Vancouver to Sydney. Bitcoin has crashed. Gold did not glitter. Commodities alone had a good year—and that was in part because of war.
The shock was all the worse because investors had become used to low inflation. After the global financial crisis of 2007-09, central banks cut interest rates in an attempt to revive the economy. As rates fell and stayed down, asset prices surged and a “bull market in everything” took hold. From its low in 2009 to its peak in 2021, the s&p 500 rose seven-fold. Venture capitalists wrote ever bigger cheques for all manner of startups. Private markets around the world—private equity, as well as property, infrastructure and private lending—quadrupled in size, to more than $10trn.
This year’s dramatic reversal was triggered by rising interest rates. The Federal Reserve has tightened more quickly than at any time since the 1980s, and other central banks have been dragged along behind. Look deeper, though, and the underlying cause is resurgent inflation. Across the rich world, consumer prices are rising at their fastest annual pace in four decades.
This era of dearer money demands a shift in how investors approach the markets. As reality sinks in, they are scrambling to adjust to the new rules. They should focus on three.
One is that expected returns will be higher. As interest rates fell in the bull years of the 2010s, future income was transformed into capital gains. The downside of higher prices was lower expected returns. By symmetry, this year’s capital losses have a silver lining: future real returns have gone up. This is easiest to grasp by considering Treasury Inflation-Protected Securities (tips), which have yields that are a proxy for real risk-free returns. Last year the yield on a ten-year tips was minus 1% or lower. Now it is around 1.2%. Investors who held those bonds over that period have suffered a hefty capital loss. But higher tips yields mean higher real returns in future.
Obviously, no law dictates that asset prices which have fallen a lot cannot fall further. Markets are jumpy as they await signals from the Fed about the pace of interest-rate rises. A recession in America would crush profits and spur a flight from risk, driving down share prices.
However, as Warren Buffett once argued, prospective investors should rejoice when stock prices fall; only those who plan to sell soon should be happy with high prices. Nervous or illiquid investors will sell at the bottom, but they will regret it. Those with the skill, nerve and capital will take advantage of the higher expected returns and thrive.
The second rule is that investors’ horizons have shortened. Higher interest rates are making them impatient, as the present value of future income streams falls. This has dealt a blow to the share prices of technology companies, which promise bountiful profits in the distant future, even as their business models are starting to show their age. The share prices of the five biggest tech firms included in the s&p 500, which make up a fifth of its market capitalisation, have fallen by 40% this year.
As the scales tilt from newish firms and towards old ones, seemingly burnt-out business models, such as European banking, will find a new lease of life. Not every fledgling firm will be starved of funding, but the cheques will be smaller and the cheque-books brandished less often. Investors will have less patience for firms with heavy upfront costs and distant profits. Tesla has been a big success, but legacy carmakers suddenly have an edge. They can draw on cashflows from past investments, whereas even deserving would-be disrupters will find it harder to raise money.
The third rule is that investment strategies will change. One popular approach since the 2010s has blended passive index investing in public markets with active investing in private ones. This saw vast amounts of money flow into private credit, which was worth over $1trn at its peak. Roughly a fifth of the portfolios of American public pension funds were in private equity and property. Private-equity deals made up about 20% of all mergers and acquisitions by value.
One side of the strategy looks vulnerable—but not the part that many industry insiders are now inclined to reject. To its critics, index investing is a bust since tech companies loom large in indices, which are weighted by market value. In fact, index investing will not disappear. It is a cheap way for large numbers of investors to achieve the average market return.
Where to worry
It is those high-fee private investments that deserve scrutiny. The performance of private assets has been much vaunted. By one estimate private-equity funds globally marked up the value of the firms they own by 3.2%, even as the s&p 500 shed 22.3%.
This is largely a mirage. Because the assets of private funds are not traded, managers have wide discretion over the value they place on them. They are notoriously slow in marking these down, perhaps because their fees are based on the value of the portfolio. However, the falling value of listed firms will eventually be felt even in privately owned businesses. In time, investors in private assets who thought they had avoided the crash in public markets will face losses, too.
A cohort of investors must get to grips with the new regime of higher interest rates and scarcer capital. That will not be easy, but they should take the long view. The new normal has history on its side. It was the era of cheap money that was weird. ■
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This article appeared in the Leaders section of the print edition under the headline "The new rules"
From the December 10th 2022 edition
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