Rates as high as summer temperatures

We hope you are having a pleasant start to summer. 

Over the past three months, financial market commentary has been driven largely by a focus on changes in interest rate policy and inflation data, with a sidebar on Generative AI (artificial intelligence). We believe interest rate and inflation dynamics will be the primary driving force in determining market movements in the medium term. 

Most Central Banks in the US and Europe have taken decisive action to control inflation. Interest rates in most of these economies are now at 5%. In Canada, the 5% benchmark rate is higher than it has been any time since 2001. In the UK, EU and US, the last time rates were this high was in 2008. Central Banks have signaled the intention to maintain these rates till inflation is brought in check. Though some of the recent readings for inflation look promising, they are still quite high compared to the prior 25 years.

The interest rate environment we are now seeing is good news for savers as CDs and money market accounts are seeing yields much closer to the historic norm in years prior to 2001. Since the mid-90s, most developed country Central Banks have maintained very low or zero interest rate policies for extended periods in response to the tech wreck of 2000/2001, the financial crisis of 2007/2008 and the Covid crash of 2020. An entire generation of home buyers, business executives and investors has spent over 20 years operating in an environment with very low or zero rates. This era is ending and the changes will have wide ranging impacts.

In the UK, Canada and several EU countries, fixed mortgage rates are uncommon. Most home-buyers obtain variable interest rate mortgages with a short fixed period. Millions of home-buyers are beginning to see their monthly housing payments creep up with interest rates. This will have the effect Central Banks want, to reduce the amount of spending in the economy, and therefore tamp down inflation. It will also impact the discretionary income and spending of millions of homeowners.

In the US, a popular Covid-era relief program is set to expire on Sept 1st as 45 million student loan borrowers will once again see interest accrue on their loans.  This policy was put in place three years ago, during the Covid lockdowns, in an effort to give borrowers some budgetary flexibility.  Like the variable rate mortgage payments in the UK, the end of this program will likely have a measurable effect on spending as households with student loans will again need to budget for interest expenses.  While this is bad news for the budgets of these households, this resulting reduction on discretionary spending will likely contribute to the cooling of inflation.

Similarly, business loans and investor margin loans have had very small carrying costs for almost two decades, Businesses looking at investments for growth now have to contend with higher financing costs. Higher margin rates will make some investments unattractive for a group of investors. All of this is designed to reduce the rate of economic activity and its inflationary impact. This will eventually be reflected in the market prices of risky assets.

Despite all this news, the stock market has been steadily rising, shrugging off the market volatility that came after the failure of three notable regional banks in March and May.  Much of the stock buying has been driven by investments in technology companies (a sector that had sold off significantly last year), and more specifically those that have anything to do with the current generation of AI technology. We believe AI is a misnomer for the technology in question. In most instances, it is the next evolution of search and natural language processing, aided by statistical analysis of documents and data made available on the internet. Intelligence, in the sense of critical thinking, is not really a part of the current generation of models. That is not to diminish their usefulness or impactfulness. We have seen very powerful results from some of the generative AI models. The ability to process documents written in human languages and synthesize information from them, has implications for every corner of human activity, including all economic activity.

As with the internet, mobile phones, cloud computing and smartphones, it will take several years for the Gen-AI market to mature. Some of the newer players will not survive, and some existing, larger entities will catch up. We are watching this space, both the core technology and its application quite carefully. However, as is often the case with market trends, the sudden rush of buying has driven valuations far higher than what is warranted and we’re seeing that again with AI-related companies.

As we’ve written in previous letters, if/when inflation is contained and the Fed signals an end to their interest rate increases, we expect risk assets to move appreciably higher.  The Fed elected to pause their rate hikes in June.  While the general market consensus is that they will raise rates again in July, most market prognosticators believe we’re in the later innings of this rate rising cycle.  If inflation data continues to cool, it’s possible that July may represent the last hike.  This, of course, remains to be seen and is dependent on the data.  However, the rally in stocks implies many investors are anticipating this regime change.  

While the Fed’s policies appear to be working to combat inflation, there are often lags in how quickly a change in rates works its way through the economy.  With the unprecedented pace at which the Fed has raised rates (a pace not seen in the 1980’s), it’s likely the Fed risks overshooting and a byproduct of taming inflation could potentially be sending the economy into recession.  There’s no certainty this will happen, but it’s been clear the Fed’s priority has been getting a handle on inflation at any cost before it becomes entrenched.  The thinking being if the economy does go into recession, the Fed can always cut rates to stimulate growth (which has worked in the past), but it has far fewer tools to handle entrenched inflation.

The second half of 2023 should provide a clearer picture on where inflation and rates are headed.  We will continue to monitor the data closely and look for investment opportunities that come as a result.

Best Regards,

Louis & Subir