CIO Lens Q2 2023: when rising rates bite

I write this after a turbulent month for markets in which the banking sector has been at the eye of the storm once again. Comparisons have reasonably been made to previous periods such as the Global Financial Crisis of 2008 and the dotcom bubble at the turn of the century, both of which I had the dubious pleasure of working through.

It reminds me of the often-cited quote from the American author Mark Twain, that “history never repeats itself, but it does often rhyme”. Past experience certainly helps in identifying the rhyme. But in recognising the idiosyncrasies that make today’s markets different, a fresh pair of eyes is helpful.

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Without doubt, we can draw some lessons from previous cycles; most notably, that when interest rates rise, this typically spells trouble for economies and markets.

The lags between policy changes and the economic effects are uncertain, but one of the ways in which higher interest rates bite is by exposing recklessness and speculation. This leads to a cooling of animal spirits, lower market valuations and slower economic activity overall.

First to fall were growth stocks and cryptocurrencies, then came the gilts crisis of 2022. The most recent victim of higher rates was the former darling of the tech start-up industry, Silicon Valley Bank. Falling deposits forced the bank to crystallise the losses on its bond portfolio and, as I write, uncertainty over bank funding costs is affecting both the US and European banking sectors. 

What’s also a common occurrence as rates rise is that seemingly idiosyncratic challenges facing a particular company can cause a domino effect to other companies as investors take a closer look at the risks across their portfolios.  

For example, the troubles at Silicon Valley Bank led to a reassessment of risk across US regional banks and then Credit Suisse. The common link being that these banks were seeing falling deposits.

This evokes memories of 2007 and 2008, although compared to back then large banks are more conservative and capital is considerably higher.

Nevertheless, we see all of this as evidence that higher interest rates are leading to tighter credit conditions and strains on the US regional banks are likely to continue. 

As a consequence, on the multi asset team we are favouring government bonds and higher quality credit as we expect the US economy to slow and move into recession alter this year.  We remain cautious on equities as, although valuations have improved, the cyclical clouds are darkening.  

To the extent that we can draw historical parallels, I continue to think that the 2000-2003 roadmap is useful.

Back then, we had a bubble in growth stocks pricked by higher interest rates. The first phase of the bear market (2000 to 2001) entailed a derating across markets as valuations adjusted to higher rates. The second and final phase in 2002 was more company-specific, with fraud at Enron, for example, causing uncertainty about the level of corporate earnings and further weakness in markets. As is often said: as the tide goes out, we find out who is not wearing any shorts.  

The current market environment reminds me of the summer of 2002 and suggests that there is a bit more work to do on corporate earnings expectations and equity valuations, but remember that some de-rating has already occurred.

But we also have to think about how each cycle is different. I have talked a lot about regime change in the CIO Lens and how we should think about what we did in the 2010s and do the opposite.  

One challenge is that, in the 26 years I've been analysing markets, I haven't seen such a persistent problem with inflation and the Federal Reserve may not be able to pivot policy as quickly as the market is now pricing. On this front, signs of softening in the US labour market would reassure investors that the Federal Reserve is close to getting its job done, and would remove a significant obstacle for markets.

This is why, although investment experience is important, it is also critical to have an inclusive investment culture, where younger and older team members can bring different perspectives to the problems we confront.

In this quarter’s CIO Lens:

• Nils Rode, CIO Private Assets, explains why he views recessions as an opportunity for private asset investments.
• Andrew Howard, Global Head of Sustainable Investment, discusses how he thinks sustainable investing has now come of age and faces the difficult realities of adjusting to maturity.
• Our multi-asset team takes you through their asset allocation views across all the major asset classes, including why they’ve downgraded credit and emerging market equities to neutral.
• Chief Economist Keith Wade and his team discuss their current economic risk scenarios.

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