Why all the interest in interest rates?

In every newspaper, on every social media platform, and at almost every dinner-party conversation, the world is transfixed on rising interest rates. This is by no means the first time rates are going up, so why all the fuss and concern?

A brief history of what got us to this point:

During the Global Financial Crisis of 2007/2008, central banks around the world (and specifically those in developed economies) reduced rates to record low levels in an effort to stave off an all-out recession. Remember what Sir Isaac Newton postulated, that for every action there is an equal and opposite reaction – in this case, the lowest interest rates in a century (action) were a necessary stimulant to economic activity and recovery (reaction). And it worked.

Following 2009 when markets and the global economy turned, the world witnessed a period of economic growth and market returns that was almost unprecedented. It certainly came with an undercurrent of volatility, but the last 13 years have been broadly positive.

These years of easy money have led the world to what we are seeing now – a period of inflation, and this at levels that were unexpected and protracted.

The supposed ‘silver bullet’ to bring inflation under control is for a central bank to raise interest rates – more money going from household’s pockets to pay down debt and at higher servicing costs, means less money to pay for goods and services i.e. higher rates (action) leads to lower demand (reaction), and eventually this should result in lower inflation.

It is important to remember that inflation is a far greater factor to consider than just how much the prices in your average shopping basket rise. Inflation really is the devil in all the detail, and affects almost everything in an economy from general economic activity, to GDP growth, government finances, and even the performance of the currency.

From an investment perspective, inflation is even a passive form of taxation – if returns do not exceed inflation, an investor’s wealth actually declines in real terms!

Hence all the fuss.

So, as central banks raise interest rates, producing an environment as detailed above, analysts, fund managers, and investors all need to look more discerningly at their investments, and reprocess their assumptions on these higher rates. Much of the last decade’s performance was earned on the back of a much lower cost of capital, and the result has been a greater leeway to shift focus slightly away from fundamentals.

Sir Winston Churchill once said to a woman who was berating him for changing his position, “When the facts change, I change my mind. What do you do, Madam?”

Unfortunately, fundamentals do matter! Sometimes it takes time to realise this, but eventually fundamentals will always matter, and we are witnessing just this right now… questions are being asked and financial models are being stress-tested to arrive at a clearer idea of what kind of performance and earnings growth is now likely to be achieved in the coming years as rates go up. And because nobody knows how high rates will go or how fast they’ll be pushed to get there, the world is awash with uncertainty.

In this environment of heightened volatility and corrections, investors’ behaviour now can easily determine the kind of performance they may achieve over the next 5 to 10 years. I have often said that the direction of markets is beyond our control, but there are two things that remain well within our control:

  1. To a degree, how our funds and portfolios behave in response to the market (proper diversification, application of risk-management, and defensive allocation of positions), and
  2. How we, as investors, behave in periods like this – not making rash, uncalculated, or emotional decisions, often at the expense of missing-out on the recovery when it comes.

A hallmark of the Octagon philosophy is to position our investors’ capital with a sufficient amount of their assets to meet shorter-term cash flow needs:

  • If you are already retired, this comes in the form of holding enough in low-risk cash, money market or fixed interest assets to meet your expenses and needs for the next few years.
  • If you are younger and still earning an income, this comes from savings and your monthly earnings.

Both of these mean you should be able to weather this storm by staying invested through the volatility, and not having to call on your money that is earmarked for the longer term.

Volatility is the price of admission to the stock market. Markets have crashed by 20% or more seven times in the last 50 years: 1973 (-48%); 1980 (-27%); 1987 (-32%); 1990 (-20%); 2000 (-49%); 2008 (-56%); and 2020 (-34%). And recovered to new all-time highs each and every time!

Stick to your plan and keep your long-term vision – because we certainly are keeping to ours!

Wishing you all a peaceful, warm, and successful week ahead!

Steve Crouse

Chief Investment Officer and Senior Advisor