Across the world, the effective interest rate set by Central Banks don’t show any signs of slowing down. Just two years ago, at the start of 2020 global interest rates hovered around 1.00% in the western world and rates, at least for the FED, ECB & BoE, are now just a few points shy from that during the 2008 Crisis. No wonder people are worried as this increase is casting some uncertainty into the relevant sectors - real estate, corporations & the financial markets.
Tenants Nowhere to be found
Increasing cost of borrowing for both developers and consumers can be attributed to be the main cause. Developers financed their projects by taking on flexible interest rate loans and with rising rates, the cost of repayments increase. This compounded with the fact that most if not all of the consumers have to finance their property needs through loans. With rising rates, consumer would rather not purchase homes with a large chunk of German developers being prone to insolvency, London's office market having vacancies hit a 30-year high and U.S. banks revealing to be spiralling losses from property.
Corporations Not Spared
Corporations similarly as stated before now have an increased stress to properly refinancing their loans. While larger firms may be able to take on the high rates for an extended period but smaller ones aren’t spared. The global corporate default was around 107, with most of the defaults coming from Europe and the United States. Not only that, the number of defaulters in August alone is the highest since the 2009 crisis.
Financial Markets Clouded
While major banks are unaffected by the increase, smaller banks are still susceptible to the increase in interest rates as they might be unable to cushion the impact of the high interest rates. Moreover, the equity of firms is now more vulnerable. With the 10-Y Treasury Yields now at an all time high at 4.93% for the US, people would rather buy these guaranteed treasury over the bonds of firms.
Moreover, depending on how the Bank of Japan plays her cards, there might be another blow. Mainly owing to the existence of a large number of Japanese Foreign-Asset Portfolios. If Japan were to pull herself out from her negative interest rate, the US market will be the one most affected.
The increase in interest rate fueled further by the increase in Treasury Yields will result in a reduction in equity in global markets.
The Certainty of the Uncertainty
High interest rates, while curbing the demand-related consumer spending, are unable to readjust changes in prices due to supply shocks. As economies recover from the pandemic, we have faced many unprecedented shocks the past few years. The Ukraine-Russia War put pressure on gas prices running throughout Europe and similarly the Israel-Hamas War to oil prices with International benchmark Brent crude closing at $93 a barrel on the 21st of October, up from $85 on Oct. 6, the day before Hamas attacked Israel. Depending on how the Israel-Hamas War develops, it is evident that this market remains volatile.
No one knows what will happen next and speculation is all we can do right now. How long will the high interest rates go on? Will there be further escalations? Will another unprecedented crisis occur? It’s uncertain and this uncertainty is casting a shadow of doubt on every possible sector.
However, all is not bleak. Markets may have already adjusted to these high interest rates.
How have the markets adjusted to the higher interest rates?
The US central bank, the Federal Reserve, has increased the interest rates to fight against the rising inflation and to support the economic recovery. This has created a new environment for the markets, which have to adapt to the higher cost of borrowing and the lower present value of future cash flows. Morgan Stanley explains that the markets have been attentive to the core inflation rate, which is still around 4%, much higher than the Fed's target of 2%. They have also been aware of the GDP growth, which has exceeded the expectations. These indicators imply that the Fed may not stop raising the interest rates anytime soon. Therefore, Morgan Stanley suggests some strategies for the investors to navigate this situation, such as choosing stocks based on their fundamentals rather than following the market index, diversifying their portfolio to balance between offensive and defensive stocks, and harvesting tax losses to offset capital gains.
Why do managers need to relearn how interest rates affect their decisions?
Interest rates have been at a historically low level for about 15 years, then they have suddenly risen to around 5%. This is a major change that requires managers and investors to adjust their behavior and mindset, according to Harvard Business Review. Managers who have experienced higher interest rates in the past will need to refresh their understanding of concepts like hurdle rates and discounted cash flows, which are used to evaluate projects and investments. Managers who have never faced higher interest rates will need to learn these concepts for the first time. The article also highlights some factors that make this adjustment more difficult, such as the extremely low level of interest rates, the long duration of this period, and the rapid speed of the increase. The article argues that managers will have to shift from a "moonshot" thinking, which was encouraged by the low interest rates, to a more value-oriented thinking, which is more suitable for the current challenges.
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