The writer is the CEO of the financial consulting company Complex.
The parties in the article may invest in securities and/or instruments, including those mentioned therein. The aforementioned does not constitute investment advice or marketing that takes into account the data and the special needs of each person
The year 2022 will be remembered as a historical turning point in the capital markets. A decade and a half of high returns in the stock markets and zero interest rates in the debt markets, ended with a sharp reversal of trend. This, against the background of the surge in inflation, which led to unprecedented interest rate increases in their speed and height, and sharp declines in the leading stock indices and bond markets.
The consequences arising from this are broad, and require thinking about the reallocation of the investment portfolios and the adjustment of the return expectations from the various avenues.
High inflation leads to significant instability in the economy and capital markets. The farther the inflation is from the inflation target set by the central bank, the larger the “error range” between actual inflation and inflation expectations, and with heavier consequences.
To illustrate, the publication of the inflation index in the US in August, which was 8.3% – only 0.2% higher than market expectations – led to a 5% collapse in the stock market. A similar gap compared to forecasts when inflation is within the target range of 2% (for example, a reading of 1.2% compared to 1%), did not cause any reaction in the market at all.
However, in an environment of high inflation, such disparities and the continued establishment of inflation in the economy, have a direct impact on the expectations of interest rate increases, which are expected to be faster and higher, and lower the value of stocks and bonds.
This illustrates that until inflation is significantly curbed, the volatility in stocks and bonds is expected to continue. Unfortunately, in my estimation, the road to curbing it is expected to be long and full of bumps for at least the next year. Investors who have become accustomed to collecting goods after falls in the stock markets will need strong endurance for a much longer and more volatile process.
Yields are returning to solid levels
Since 2008, investors have gotten used to the “risk-free” avenues, such as government bonds, yielding zero returns, and have seen them primarily as a tool for liquidity management, and an investment for those with an extremely low risk appetite. Now, the expected increase in interest rates to around 4-5%, produces a relatively high return , even if it is still negative in real terms, and justifies a much larger place in the portfolio for solid debt assets, especially in light of the high volatility in the stock markets.
In my estimation, in allocating investments to the solid debt channels at the present time, there is a preference for investing in short-term bonds. This is not only due to the fact that the returns in the short-term bonds provide returns similar to those in long-term bonds, but mainly from the uncertainty regarding the Fed’s final interest rate target, which in the scenarios Extremism may increase significantly further and cause sharp declines in the long-term average.
Risk premiums and return targets have fallen
On the other hand, after the completion of the expected interest rate increases in the US by the end of 2022, to around 4.5%, and as soon as there are signs of a decrease in inflation and a slowdown in the economy, so that interest rate expectations will begin to decrease, the priority will be to invest in long-term bonds, which will be able to generate capital gains from the decrease in interest rates In the future, back to the Fed’s long-term neutral interest rate range, which ranges between 2.5%-3%. Contrary to intuitive thinking, interest rate increases are actually expected to lower yields and risk premiums far below what investors have become accustomed to receiving.
For example, companies that issued bonds and took out loans are expected to transfer value from shareholders to debt holders, who will now receive much higher interest rates, hurting returns on capital.
Another example is private equity funds, which flourished under the auspices of the zero interest rate and presented high double-digit returns. This, against the background of zero capitalization rates for the assets they purchased, which inflated the value of the future cash flows expected from them and as a result also the valuations, as well as against the background of the great leverage taken in the acquired companies, thanks to the low financing costs. The enormous liquidity created in the markets also contributed to these funds and created a wide and generous circle of buyers for the companies in which they invested. The increase in interest rates and the pumping of liquidity as part of quantitative easing by the central banks will eliminate these optimal conditions.
As a result, in my estimation the era of target returns of 12% to 15% is over. Average target returns for equity investments of various types will be 8% to 10%. Another conclusion is that, while in the last decade the returns achieved were also presented to investors as risk premiums in relation to zero interest, and increased the viability of the investment, now the risk premium for risky assets will drop to only about 5% on average, compared to a risk-free interest rate that will vary between 3% and 5%.
In the face of rising interest rates, falling risk premiums and high volatility, in my opinion the order of the hour for investors for the coming years will be to find stable alternative anchors in the investment portfolios, which yield target returns of about 8%, similar to the long-term return of the stock market, but with lower volatility and with little exposure for heavy losses in extreme scenarios.
Such investment options are few, and often require expertise possessed by only a few specialist managers, who are usually not accessible to the general investing public.
Examples of this may be investing in CoCo bonds of leading global banks, in a wide spread, which in my estimation currently yield high returns that far exceed the risk, given the high levels of capital and liquidity and the tight regulatory oversight.
Another example is investing in consumer credit funds, a channel that consistently yields higher returns than risk-free interest rates, at a much lower risk compared to channels that yield similar returns, while being stable even in extreme scenarios. This, in light of the high interest rates, which exceed the failure rates even during a crisis, the wide spread and the short interest rate, which allows quick adjustments in portfolios when market conditions change.
The era when “every broom shoots” is over
The zero interest rate environment and the rising markets led to the flourishing of alternative investments and allowed many managers, even those who lack a relative advantage and specialization in the markets in which they invested, to generate high returns and portray themselves as professionals. It is enough to see the amount of alternative funds that have been established in recent years, and the amount of Israelis who claim to manage investments in foreign markets, without presence or expertise in them, while presenting apparent “excess returns”, under the auspices of the rising market and against favorable benchmarks.
In my opinion, the days of easy successes are over. The coming years will illustrate the obvious priority of investing through managers with specific expertise and a significant presence in the markets in which they operate.
Adjustments are required in the investment portfolio upon entering the new economic era
- The rise in interest rates justifies an increase in allocation to solid debt assets
- In the allocation of investments between the solid debt channels at the present time there is a preference for investing in short interest rates
- The era of target yields of 12% to 15% is over. The average target returns for equity investments will be 8% to 10%
- The hour order is an alternative anchor that yields target returns of around 8%, but with lower volatility