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What Higher-For-Longer Rates Mean For Investors

October 9, 2023 12 min 37 sec
Luc de la Durantaye
CIBC Asset Management
Interest rate chart
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Welcome to Advisor ToGo, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.

Luc de la Durantaye, Chief Investment Officer, CIBC Asset Management.

Definitely the higher-for-longer trend for interest rates has now resumed, and I say this because it’s been interrupted by the U.S. regional banking crisis and the government debt ceiling between March and May of this year. But interest rates, before that had been, if you look at a chart, interest rate had been on a rising trend since the lows of the pandemic in mid-2020. This rise, the continuous rise of interest rates is the reflection of a very different macroeconomic environment that we had been accustomed to during the global financial crisis.

The new environment, if I can describe it quickly, is one where government spending is very high, considering we have been in an economic expansion. Usually, the kind of large fiscal deficits we see in the U.S. and Canada, even in Europe, is during a recession, not during an expansion. The U.S. deficit will be, for example, more than 6% GDP.

And if you look at the Congressional Budget Office forecast, which is a bipartisan organization that looks at the fiscal deficit and debt projection for the long term, they say the deficits will continue and debt will continue to grow over the coming few years. So that’s one very different environment because after the global financial crisis, governments were actually doing fiscal retrenchment. So that’s one change.

The other change is central banks are engaged in removing their Covid stimulus in two ways. One we’ve seen already, they’ve raised their policy, Fed fund policy for example, one of the fastest tightening that we’ve seen. And that’s because we have high inflation, which was not the case after the global financial crisis. And they’re also engaging, and this is what pertains also to the long end of the bond market, is they’re reversing their quantitative easing with quantitative tightening. This is really only the second time in history that they’re trying to do this. So they’re letting their bonds mature and that’s shrinking their balance sheet. So you have their removal of an important buyer in the bond market.

The world economy is also engaged in an energy transition that requires enormous investment for new sources of energy like wind, solar, nuclear, et cetera. Investing in renewing old infrastructure, there’s also a need for that and investing in new promising technologies. So there’s a lot of investments.

So this is all occurring at a time when the world population is aging. And what that means is that older generations are not saving, they’re saving less. So when you draw a conclusion, if you look at this picture, the global pictures, we have an imbalance because on the one hand you have less buyers of bonds. Central banks are not buying bonds anymore, they’re either letting them mature or selling them. Individuals are buying less than before because they’re retiring. So on one hand you have less savings and on the other hand you have more demand for investment.

Governments are dis-saving, they’re spending too much, so they’re issuing a lot of bonds. And corporations will be issuing bonds to their investment in that energy transition and technology investments. So you have an imbalance between, you have less buyers of bonds and you have more issuance of bonds, and that’s what creates this imbalance. And that’s what’s pushing interest rates higher. And they will be higher for longer because these are longer term trends.

So that’s the dilemma that we’re in. That’s the new environment that we are in.

How does that affect our outlook for bonds? Well, we’re trying to assess where we are in this repricing of bonds. Part of that depends on your economic outlook. And that economic outlook we have is one where we’re going to continue to, the main scenario we have, we’re going to continue to see a deceleration in growth because you’ve had a rise in interest rates. That is going to continue to impact the outlook for the economy.

And the central banks will not ease at all until they see pressure on the labour market at base. You have to see less wage growth, you have to see a less tight labour market, and we’re not there yet. So you need to see more evidence that deceleration is occurring before they can, one, pause and eventually consider easing monetary policy.

Since the yield curve is still somewhat inverted, you’re not rewarded enough to take on a longer maturity in your portfolio. So if your scenario is one of a continued deceleration in growth, you have an inverted yield curve, you don’t necessarily want to be too far into the spectrum in terms of duration. It’s only if you were to create and construct a stronger economic weakness, like a material recession, then you could start considering longer maturity. But I think the evidence is probably there for at least a continued slowdown. But it’s not there to say that you’re going to be in a recession and therefore you want to enter long bonds at this point.

So again, if you continue with the scenario, if you have a deceleration, you want to continue to stay defensive until the economic outlook of a more pronounced deceleration occurs. So you want to avoid the economic risk. So we’re considering being neutral in terms of investment grade, underweight high-yield, and wanting to look for opportunities in emerging markets.

So there’s a whole world within emerging market, and you have to be very selective. These markets offer much higher rates in a global deceleration environment. And when the Fed starts to signal a pause, that’s going to be a more attractive environment for a number of these economies because they’re starting from very high rate and they have room. Because inflation has come down, they have a lot of room, they have very high real yield. That’s going to create some opportunities in some selective markets.

And some of these countries, funnily enough, they’ve been running fiscal policy much more prudently than a number of developed markets. I’m thinking of Mexico for example, they’ve been running a much more prudent fiscal policy. Indonesia, same thing. So that you have a number of economies that are providing some very attractive real yields at the moment. And as soon as you get a little bit of an easing or plateauing in rates from the Federal Reserve, those are going to be some attractive opportunities.

So in terms of our preferred environment first being more into sort of mid to shorter end, because the yield curve is inverted, you’re looking at being careful with some of the credit side of things like investment grade and underweight, even high yield, neutral on the emerging markets. But looking for opportunities, emerging market bonds. And looking for opportunities as you see the development of that economic slowdown.

About equities, equity is a bit tricky because again, to go back to the basic economic slowdown scenario, there’s a number of markets that you want to understand a little bit what will be the impact on earnings. Because the price to earnings at the moment is relatively high, and you also have interest rates that are providing a lot more competition to equity markets at these levels. So you want to be making sure that you want to be in equities that are going to be able to sustain their earnings, because you already have fairly high competition on the fixed income space, even in the short term, which provide very low volatility relative to equities. And so, you want to see that economic scenario unfold and having that sustainability and earnings before you want to commit a lot more.

So we’ve been underweight in some of our strategies. We’ve been underweight equities in general. We’ve been underweight the U.S. in particular. But again, it’s that unfolding of that economic scenario that you want to see a little bit more of before you want to commit a little bit more on the equity side.

I think the environment for currencies is interesting because, in that environment, there’s decoupling between different areas. There’s decoupling with China and Asia. You see that China is lowering interest rates. A number of countries there have started to, they’re close to their peak of interest rates. Whereas, a number of Western economies are continuing to raise interest rates, and so that creates very different economic cycles.

The currencies are driven a lot by interest rate differentials, and that creates a very wide interest rate, differential gap. So between China, who has China, Taiwan, Japan, and somewhat the Euro zone, which have started to signal that they may have ended their tightening cycle, they offer very low interest rates. And so, their currencies are weakening. So you can underweight these currencies and overweight some of the currencies that are offering very high interest rates. Again, we’re going back to the same ones like Mexico, India, Brazil, that offer a very large interest rate differential.

So that’s opportunities within portfolios that we can take advantage of. Look for unfolding opportunities is what I would say. There’s always fear in this environment where central banks sound more aggressive and that creates maybe a bit of a passive approach by investors. But on the contrary, I think where there are changes in the market, there are opportunities. And we think the coming months will provide attractive investing opportunities.

The tightening cycle for many central banks is coming to an end. It’s come to an end in a number of emerging markets. It’s going to come to an end in developed markets. And in many emerging markets, a number of central banks will have to leeway soon to continue, because some have started to lower interest rates and stimulate their domestic economy.

So each central bank will provide better entry points in the bond market and it will provide attractive opportunities in some of the emerging countries.