Navigating a High Interest Rate Environment

What got us here and what is to come

Recent market performance has been primarily driven by interest rate rises by the central banks along with market sentiment on where interest rates are headed. Since June 2021, short term bond yields have seen a steeper increase than longer term bond yields, leading to an inverted yield curve, (commonly used as an indicator of upcoming recession). On the other hand, equity markets which echo investor sentiments on future corporate earnings have shown more optimism with the S&P 500 index rallying over the last few weeks, recovering half of its losses this year (Reuters).

The bond and equity markets seem to be demonstrating different views on risk since the start of July which saw the S&P 500 rallying for the first time since 2020. The differences in the bond and equity market performance could be due to behavioral aspects at play within the equity markets, where irrational investors cause securities to be mispriced. We have seen the equity markets rallying on the back of investors' expectations for a slow down in interest rate increases. This begs two important questions: 1) When will the major central banks, namely the Fed and the ECB stop interest rate hikes? 2) Is the rallying of the equity markets sustainable?

1) When will the major central banks, namely the Fed and the ECB stop interest rate hikes?

To answer this question, first we need to understand the reason behind the hikes. The contractionary monetary policies employed by the US Fed and European Central Bank (ECB) were employed to control inflation driven by the shock in energy and oil prices following the sanctions placed on Russian exports. Despite its most aggressive interest rate hikes since 1994, the US benchmark rate was raised by 75 basis points consecutively in June and July, the Fed still bears a hawkish view on interest rate hikes and states that a further 50 to 75 basis points hike is likely to happen in September (CNBC).

Along with interest rates increases, the Fed has engaged in quantitative tightening, a monetary policy characterised by a reduction in the assets held on the Fed's balance sheet by slowing down bond purchases and allowing maturity bonds to roll off. While the U.S. Bureau of Labor Statistics reported annual inflation rate dropped from 9.1% (June) to 8.5% (July), the inflation rate is still far off the 2% target set by the Fed. Assuming that inflation drops steadily by 0.6% month-on-month, it would take about 10 months to reach the Fed's inflation target.

The assumption of inflation dropping steadily month-on-month is perhaps a dovish view on the inflation rate, given that components of inflation such as shelter costs and wages are sticky upwards (CNBC).

Moreover, the inflationary pressures on commodities and food caused by supply-chain distruptions and extreme climate conditions were already an on-going issue before the war. Since the problem with high inflation lies with supply, it is likely that monetary policies that aim to curb demand may have little impact on bringing down price pressures on these commodities and food.

Hence, we should expect to continue seeing interest rate hikes by the U.S. Fed well into 2023.

2) Is the rallying of the equity markets sustainable?

The stock market has just ended its fourth straight week of gains, with the S&P 500 closing 1.21% lower, Dow 0.16% lower and Nasdaq 2.62% lower.

The reason behind the stock market rally was likely driven by a phenomenon known as a short squeeze, where the initial rally in the stock market caused panicked short sellers to buy back on positions that they have borrowed, inflating demand and thus the stock price (Bloomberg, Reuters). However, Bloomberg reports that derisking activity from equity hedge funds have slowed down since the week beginning 12th of August. Since the temporary high volume of short covering that was driving stock prices up is petering out, this could signal that the end of the stock market rally is near.

Nonetheless, could we potentially see a rebound of the equity market into a bull market territory?

Given that the stock price is driven by fundamental factors (company's earnings and profitability) and technical factors (investors' sentiment), the high interest rate environment coupled with the market uncertainty, point to corporate earnings and profitability headwinds. In this current macroeconomic environment, corporate earnings is impacted by the cost of capital.

Companies that need capital to either grow or manage their operating activities will have to pay an inflation and volatility risk premium. Indeed, the first half of 2022 saw a cool down in capital markets, with global equity issuance down 67% and global debt issuance down 14% year-on-year (Refinitiv). Hence, to maintain a positive cashflow, these companies will either have to cut back on their investing and financing activites. For instance, dividend-paying stocks may cut back on their dividend payout, sending out a negative signal on a company's projected earnings to investors.

Another headline to look out for in corporate performance in the upcoming months is the balance sheet impact of companies with a high debt to equity ratio in a high interest rate environment. Financial institutions and companies have been benefitting off a period of "cheap money" as central banks in major economies have adopted expansionary monetary policies to boost the economy following a pandemic-induced economic contraction. As a result, corporations have taken advantage of the low interest rate environment, taking on more debt into their balance sheets. Given that there is little indication of an ease in interest rate hikes, companies with short-term debt approaching maturity will have to refinance their debt in a high interest rate environment. This would have a severe impact in a company's net income and retained earnings.

Hence, considering that the July equity market rally could be explained by a temporary unwinding of short positions, and that corporate earnings will be impacted by the cost of capital, a continuous and sustainable rally in the equity market seems highly unlikely at this moment.