So, interest rates are going to rise…
Central banks in the United States and the UK are finally embarking on a rate hike cycle and that means that interest rates are slowly normalising. And while I doubt we are ever going to get back to the interest rate levels we had before the financial crisis of 2008, the rise in interest rates could have more than just the usual consequences.
The usual consequence of rising interest rates is that all future cash flows are discounted with higher rates, which means that equity valuations decline (more so for growth stocks than value stocks which is why value outperforms growth in times of rising rates), but so do bond valuations. That’s bad news for the classic stock/bond portfolios because they suffer on both the equity and the bond side. But whether alternative investments are able to diversify this interest rate risk is open to debate. The track record of most alternative assets in times of rising interest rates is very poor and I don’t have high hopes that this is going to be different this time.
But have you thought about the structural shift towards riskier assets we have seen over the last decade? The chart below is from a study of Swiss pension funds. As bond yields in Switzerland have declined, pension funds were forced to reach for yield and make up lost bond income with higher allocations to risky assets like equities. Thanks to a 10-year bull market between 2009 and 2020 this has proven fortuitous for pension funds everywhere because the outsized returns on equities more than compensated for the lower returns on bonds.
Pension funds have been reaching for yield for a decade
Source: Kroencke and Salva (2022)
But let interest rates become higher for longer and I would expect this reach for yield to unwind again. Just as equities become cheaper, pension funds will become tempted to reduce equity allocations and shift them back into bonds in order to reduce risks in their portfolios. Swiss pension funds went into the pandemic of 2020 with the highest allocation to risky assets ever (and they got lucky, equity markets recovered so quickly, or else they would be in deep doodoo now). It seems likely they will again act procyclical in reducing equities in times of rising interest rates.
The good news is that in my opinion, pension funds will once again get lucky because not only do I believe that interest rates will not go back all the way to the levels we were used to 20 or 30 years ago. I am increasingly convinced that the rate hikes this year will, together with high inflation create a recession (or at least a high risk of recession) that will force central banks to cut interest rates again. And that, ironically, should support both bond and equity markets and thus help pension funds once again avoid the consequences of pro-cyclical decision-making.