Welcome to the end of cheap money. Stock prices have been through worse, but rarely have things been so bloody in so many asset markets at once. Investors are in a new world and they need a new set of rules.
The suffering has been intense. S-index
The shock has been even worse because investors have become used to low inflation. Following the global financial crisis of 2007-2009, central banks cut interest rates in an attempt to revive the economy. As rates fell and stayed low, asset prices soared, entrenching a "bull market in everything." From its minimum in 2009 to its maximum in 2021, the S
The drastic change in trend this year has been caused by the rise in interest rates. The Federal Reserve has tightened its monetary policy faster than at any time since the 1980s, and other central banks have been dragged down by it. However, looking deeper, the underlying cause is a resurgence in inflation. Across the rich world, consumer prices are rising at their fastest annual pace in four decades.
This age of more expensive money calls for a change in the way investors approach the markets. As reality sets in, investors are scrambling to adjust to the new rules. They should focus on three.
One is that the expected returns will be higher. As interest rates fell during the bull years of the 2010s, future income was transformed into capital gains. The counterpart of the rise in prices was a lower expected return. By symmetry, this year's capital losses have a silver lining: real future returns are up.
This is easy to understand when we consider Treasury Inflation-Protected Securities (TIPS) issued by the US government, which have yields that are a proxy for real risk-free yields. Last year, the yield on a ten-year TIPS was less than or equal to 1%. Now it is around 1.2%. Investors who have held those bonds during that period have suffered a heavy loss of principal. However, higher TIPS returns mean higher real returns in the future.
Obviously, there is no law that says that asset prices that have fallen a lot cannot fall further. Markets are nervous awaiting signals from the Federal Reserve regarding the pace of interest rate hikes. A recession in the US would crush earnings and cause a flight from risk, sending stock prices down.
However, as Warren Buffett once argued, potential investors should rejoice when stock prices fall; only those who plan to sell soon should rejoice at the high prices. Nervous or illiquid investors will sell at the lowest point, but will regret it. Those with skill, boldness, and capital will take advantage of the higher expected returns and prosper.
The second rule is that investors' horizons have shortened. Rising interest rates make them impatient as the present value of future income streams decreases. That has dealt a severe blow to the share prices of tech companies, which promise bountiful profits in the distant future, even as their business models are beginning to show their age. The stock prices of the five largest technology companies included in the S
As the balance tips from new companies to old ones, seemingly burnt-out business models like European banking are going to find a second life. Not all start-ups will lack funding, but checks will be thinner and checkbooks will be swung less frequently. Investors will have less patience with companies with large start-up costs and far-off profits. Tesla has been a huge success, but traditional automakers suddenly have an advantage. They can draw on cash flows from previous investments, while even deserving potential disruptors will have a harder time raising money.
One part of the strategy seems vulnerable, but not the part that many industry insiders today are inclined to reject. For critics, index investing is a flop, as tech companies are big in indices, which are weighted by market value. In reality, index investing will not go away. It is a cheap way for a large number of investors to achieve average market returns.
It's those high-paying private investments that deserve scrutiny. The behavior of private assets has been much touted. By one estimate, private equity funds globally increased the value of the companies they own by 3.2%, even as the S
It is largely a mirage. Since private fund assets are not traded, managers have wide discretion over the value they place on them. They are extremely slow to cut them down, perhaps because their fees are based on the value of the portfolio. However, the fall in the value of listed companies will end up being felt even in privately owned companies. In time, investors in private assets who thought they had prevented the collapse of public markets will also suffer losses.
A whole generation of investors must adapt to the new regime of higher interest rates and scarcer capital. It will not be easy, but they must take a long-term perspective. The new normality has history on its side. The strange thing was the era of cheap money.
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Translation: Juan Gabriel López Guix
