Advisory Intelligence: The shape of rates to come

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The role of low interest rates has been a big point of economic debate, with a 2017 IMF report warning that maintaining them at such low rates could put the global financial sector at risk. Chris Scully, a Chicago-based analyst at Nasdaq IR Intelligence, understands this message. ‘A prolonged period of low interest rates is not really healthy for the market, because what we start seeing are investors taking too much risk. Also from a business cycle perspective, if rates stay low forever you may not see companies investing much in development but instead, fueling their own corporate buybacks.’ 

So how could this extended period of low interest rates impact on capital markets? Scully says: ‘The Fed is currently steering the economic ship to the best of its ability. But from a psychological point of view, the Fed’s long-term commitment to providing accommodative monetary policies has instilled confidence in investors. In the sense that the conventional wisdom has been that the Federal Open Market Committee will be backstop in the event of a market slowdown.’ 

Scully observes that in practice, we have seen investors view a historically low interest rate environment as a means to gain inexpensive leverage to invest in a wide array of investment classes, such as stocks, bonds and real estate. ‘As it relates to investment, the deployment of capital with leverage in the US stock market has led to its second longest bull market in history,’ he notes.

That picture however could be set to change. During 2018 as the Fed has unwound its accommodative monetary policies and continued to normalize interest rates, we may expect, says Scully, market volatility to rise. ‘We need to consider that the extended period of historically low interest rates may have played a significant role in tempering market volatility,’ he says.

‘If we take a deeper look at the market’s major volatility benchmark, the VIX (CBOE Market Volatility Indicator), we’ve seen a number of prolonged periods of historically low market volatility in recent years when compared to historic levels. The real world impact of the low interest rare environment has been as the combination of easy access to inexpensive capital and past confidence in central banks has helped quell market fears leading to less volatility in the market.’ 

We may also see the deleveraging effect in a rising interest rate environment can heighten market volatility. Scully expands: ‘For instance, we may see a slowdown in corporate buybacks as it becomes progressively more expensive for companies to finance buybacks and less attractive to do so ten years into a bull market.’ 

Therefore, as buybacks slowdown, companies may be prone to see more frequent price swings as market participants take a hard look at what prices they are willing to pay without that steady source of buying that comes from buybacks.

From an investor perspective, the rise in market volatility actually provides a great buying opportunity for savvy portfolio managers. ‘We’re may see more of a stock picker’s market where the top portfolio managers aggressively buy attractively-priced companies with a strong fundamental backdrop. Investors may be looking to invest in companies that are able to appreciate in prices even as access to inexpensive leverage dries up,’ says Scully. 

Here Scully provides a proviso, in that we have seen passively-managed index funds play a dominant role in the market as the index crowd has participated in the market increase in recent years. 

And when it comes to a volatile market environment, we will see investors deploy capital in the stocks that best suit their investment strategies, notes Scully. ‘Investors will look at blue chips as we head deeper into the market cycle,’ he adds.   

As for the IR professional in a rising interest rate environment, it will be the sophisticated IRO who will take a deep look at what makes their company an attractive investment opportunity for portfolio managers from a fundamental perspective. ‘The key question that IROs will want to ask themselves is how can we best speak to our company’s ability to generate steady cash flow – because in an environment where access to inexpensive capital becomes increasingly more scarce that is exactly what Wall Street will reward in a rising rate environment.’

IROs here should brush up on the whole fundamentals side of the company and economic equation. ‘It is about being able to speak about what is going on regarding their cash flow statement and balance sheet and their ability to maximize return on invested capital ,’ says Scully.

Inevitably all this is related globally. ‘We are all linked at the hip. The European market is sensitive to what takes place in the US and the US is sensitive to what takes place in both Europe and Asia.’   

Within this outlook could it all be scuppered by the criticism from President Trump who wants a more politically expedient approach, especially in regards to the Fed? ‘It is difficult to predict what the President will do,’ admits Scully. ‘We have seen a more hawkish approach from the Fed with the appointment of Chairman Powell. But the biggest thing we do need to keep an eye on is any unusual surprises.’ And of course, this is a President that specializes in surprises.  

Concluding, Scully notes on a potentially stormy outlook once the low interest environment breaks: ‘I think it is worth keeping in mind as we start seeing periods of market volatility we may actually see a more extreme straight impact in the markets as investors will look to rebalance their exposure to various asset classes.’