Higher interest rates and inflation as well as lower growth offer opportunities

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I see the evil moon rising
I see trouble on the way
I see earthquakes and lightning
I see bad times today

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Don't go around tonight
Well, it will cost you your life
There is an evil moon rising

~ Creedence Clearwater Revival

If you had asked me before the global financial crisis of 2008 what would happen if the Federal Reserve and other central banks cut interest rates to zero and then left them there for more than a decade, I would have told you that it would not be long before the world faced a serious inflation problem. I would have been very wrong.

The Phillips Curve is an economic concept developed by William Phillips that states that there is an inverse trade-off between unemployment and inflation. All other things being equal, lower unemployment leads to higher inflation, while higher unemployment is associated with lower inflation.

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This theory proved largely consistent throughout most of the post-war period. However, there was a notable exception in the years following the global financial crisis. From 2009 to 2021, world prices remained unexpectedly low despite unprecedented monetary and fiscal stimulus and record low unemployment.

In the years following the global financial crisis, the Phillips curve appeared to have shifted downward, allowing central bankers to keep interest rates at extremely stimulative levels for extended periods without boosting inflation. This dynamic persisted into 2021, when COVID-19-related stimulus measures and supply chain disruptions caused prices to rise and forced central banks to raise interest rates aggressively.

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Falling interest rates: How do I love you?

Low interest rates make it easier for consumers to borrow money for purchases, which in turn increases businesses' sales and revenues. They also increase businesses' profitability because they lower their cost of capital and make it easier for them to invest in plant, equipment and inventory.

Lower interest rates also lead to higher multiples, from increased P/E ratios on stocks to higher operating income multiples on assets such as real estate.

“Interest rates drive everything in the economic universe,” said Warren Buffett. “They act like gravity on valuations. When interest rates mean nothing, values ​​can be almost infinite. When interest rates are extremely high, that has a tremendous pull on values.”

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The impact of higher earnings and valuations resulting from disinflation cannot be overstated. Based on monthly data, the S&P 500 posted an annualized return of 18 percent from the low point of the global financial crisis in late February 2009 through the end of 2021, roughly double the index's long-term average.

Perhaps the most important factor that enabled this sustained “Goldilocks environment” of strong growth, low unemployment and low inflation was a dramatic increase in global integration and trade.

In the 30 years between 1991 and 2021, total international trade increased from around 37 percent of global gross domestic product to 57 percent. This increase is mainly due to the continued rapid growth of the Chinese economy and its rapid integration into the global economy.

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There were other factors that kept inflation under control. Technological advances in particular undoubtedly played a role. But the China effect contributed significantly to disinflation in the post-global financial crisis period. However, this deflationary influence is either fading or reversing completely.

Populism, politics and deglobalisation

Anti-trade rhetoric is becoming increasingly prevalent, especially between the US and China. While Democrats and Republicans seem to disagree on whether the earth is round or flat, there is nevertheless bipartisan support for tariffs and other trade restrictions.

The likelihood of greater global economic integration in the foreseeable future has also been reduced by a series of geopolitical conflicts that have prompted companies to reassess their supply chains and explore nearshoring opportunities. “Just in case” is replacing “just in time” as the guiding principle for companies looking to strengthen their supply chains.

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At the same time, China's population is aging rapidly, contributing to a growing labor shortage. The number of employed people shrank by 38 million in the ten years to 2020. In contrast, the number of people over 65 rose by 60 percent. In this context, Chinese wages have doubled since the global financial crisis.

Given that China is at the centre of global manufacturing and accounts for around 20 percent of the world’s working-age population, rising wages in the “factory of the world” will dampen its historic disinflationary impact and could push up price levels worldwide.

In addition, in most major economies, the ratio of the working-age population to the number of retirees is deteriorating. In his book The Great Demographic Reversal, Charles Goodhart, a professor at the London School of Economics, argues that the ageing population will drive up inflation. In particular, he believes that older people will continue to consume goods and services even as their retirement contributes to a labor shortage.

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Impact on investments

While these developments do not mean that interest rates cannot fall from current levels, they do suggest that the neutral framework of monetary policy (the interest rate that is neither inflationary nor restrictive) could be higher than what markets are accustomed to.

A secular shift toward a regime of lower growth, higher inflation and higher interest rates has significant implications for markets and portfolio positioning. In particular, such a change would initiate a disruption or complete reversal of many long-standing investment themes and outperformers that have characterized markets in recent years.

Not surprisingly, yesterday's darlings, which include private equity (PE), venture capital, technology stocks and other long-dated, high-growth assets, are the very same asset classes that have benefited most from an unusually favorable mix of strong growth and low interest rates.

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Their future prospects will be most affected by a return to a more normal macroeconomic environment, so investors would be well advised to reduce their exposure to private equity, venture capital and growth stocks in favour of value stocks and high-quality bonds.

Noah Solomon is Chief Investment Officer at Outcome Metric Asset Management LP.

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