The Force of Gravity
There is nothing more powerful in the universe than the gravity force—a mighty and always present power that shapes our understanding of the world. There is a similar robust presence in our money world. An element to which every asset, debt, or flow of money is tied and measured is the interest rate on government bonds.
Where gravity force is weak, escaping to orbit or jumping is done more easily than on our earth. In finance, a low-interest-rate environment, as we had in 2020 with plenty of quasi-free money, has a similar effect. Every company looks like a space rocket ready to go to outer space with little effort.
When this "force" slowly increases via higher government bond interest rates, it reaches a certain breaking point when Mr market psyche suddenly starts to care. If the interest rate increase is sustained over the long term, it will matter a lot more over time. It feels like we are in the mighty gravity force of Jupiter in a second. And that was what began to happen this last week of February 2021.
The government interest rates for the ten-year US government bonds (usually the benchmark) reached 1.5% per year last week, from about 0.5% at the deep of march 2020, not by any chance a "Jupiter" level environment. We are at a reasonable interest rate level compare to the last twenty years. Still, this new interest rate in the markets dragged down every investment the previous week, a scare reaction of sorts.
Mr. Market tends to amplify and exaggerate everything in the short term, and this opportunity was no exception. So is this end of a world event? No, not yet, at least. We could not be sure the interest rate will continue its current path or just bounced around. And suppose interest rates increased over an unhealthy limit. In that case, it might be in the Federal Reserve's best interest to exert its influence to indirectly or bluntly control them. Of course, it might cause the USD exchange rate with other currencies to adjust
Though it feels there is a different game now. Any investment upside will have to prove worthy, at least in the short term. Investors might ask for more profits and certainty over their investments. Suddenly, any investments might require more uplift power to succeed. A refreshing sentiment, if you ask me, a more rational one.
Now, why the USD interest rate is going up? It is relevant to understand the mindsets behind these changes to our investment plan. Among many, there are two most opposing but widely discussed within financial circles:
1) An accelerating economy.
The US economy and the rest of the world are accelerating their growth, or it is expected to. It is a very reasonable assumption because we were shut down or partially functioning for so long due to isolation.
Therefore, there might be significant growth ahead due to a successful vaccination effort and ample financial liquidity support from central banks and government aid programs. It might generate a temporal inflation bump due to production capacity constraint in the short term, but a benign and desirable one. It might adjust currencies slightly in the US exporter's favor for a while. Or it could be that ...
2) Unforeseen consequences of excess liquidity
There could be signs that the financial aid of 2020 and future 2021 plans might cause uncontrolled inflation. If this were to happen, we could see an extreme inflationary environment and lack of economic growth, commonly known as stagflation. It could be the worst possible "nightmare" scenario. The US dollar might lose purchasing power drastically, and it could redraw the global economic power balance.
You might call me an optimism; I choose the first alternative, " An accelerating economy," as the most likely. There are, of course, several levels of gray between those scenarios, but let me explain my reasoning.
A little inflation is healthy to a limit. Negative inflation or "deflation" is terrible. And too much inflation is catastrophic. In the last two decades in the US, generating that healthy low-level inflation has been challenging. The Federal Reserve has tried to increase it without success for a while.
I know what you are thinking; why on earth will anyone like any inflation at all?. We are always trying to beat inflation in our investments; that evil phenomenon is always eating our purchasing power. Why are central banks looking to get some? Well, because there are debts, and we as humans are biological entities that depreciate over time.
So those who use debt to create value and purchase valuable things, such as corporations, investors, entrepreneurs, and almost every family, and of course, our governments benefit from inflation greatly.
If you own a mortgage at a fixed rate, any inflation will lower those payments. At the same time, your income might increase with inflation; your debt payments will not. The same case with governments; their government debt is easy to manage with a little inflation, but not too much. A zero or negative inflation system will feel like a nightmare to those who owe money.
So two critical questions to consider: how much inflation could we get?. If we do get more inflation, how do we protect our investments?
Deterministic forecasting of economic variables has a highly inaccurate track record. It could be a fool's errand. Even if you could have perfect foresight, what matters is what investment will benefit or not under such a scenario.
Under a higher than usual inflation, you will like to own investments that could easily overcome it and even thrive as an investor. Any asset with a fixed payment and no growth adjustment over time is fatal; it will most likely lose value. Therefore, fixed income or bonds, unless in a few exceptions like actively managed funds with alternative tools, will not be wise. So if you need a constant flow of income, you must be very selective.
Historically, and in my humble opinion, stocks are the best asset class to fight against inflation pressure. But not all stocks are created equal for this set of conditions.
Companies with real growth on near-term earnings fare better than any company with stagnate earning growth or no earnings at all. Usually, this kind of company has a distinctive market power that allows them to adjusts prices above inflation without affecting market share.
At first, it will look like dividend-paying stocks will do better than others, but usually, only those who can increase those payments over time excel. So it is more important to consistently increase those payments than the actual amount of those payments that matters the most.
Of course, the high value of today's market needs to be considered. As the interest rate rises, market participants could reassess their risk vs. return balance. A rotation of sort within the stock class could start to reflect the relevance of short-term certain cash flows vs. uncertain long-term promises. As usual, only time will tell.
Be mindful of sudden changes in interest rates; its force is mighty. A careful review of your investment might be a worthwhile effort, and in case you need any support, you know where to find me.