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Are we in a « low forever” situation? The current equity market performances and S&P500 rally can be explained partly by this feeling that low interest rates even long ones will last for an extremely long period of time. It is always difficult to predict the future based on a look at the rear-view, especially when you reach regions never hit before. The past is not always the best indicator for guessing future. However, we should be prepared to revise our standards and referential.

 

New mantra

 

As often mentioned in my previous articles, I keep thinking we will face a low interest rate period for a long period of time and I do believe we entered even before COVID into a “low forever” cycle on rates. These low rates quasi everywhere I Western economies and top currencies illustrate this new situation and explain the stock exchanges rallies, despite poor fundamentals and high unemployment rates. What is amazing in the current recovery is the speed. Do not forget that in 2008, it took four years to recover former pre-crisis level. It does not look like a “normal pattern” for a major financial crisis. I admi that these days nothing is “normal”. Nevertheless, I am puzzled by the turnaround and can not imagine that only low interest rates and performances of some “winners” after health crisis can explain current rally on equities. The fast and powerful reactions of central banks helped. But I am afraid that some investors are blinded by some lights and do not look at the full picture. Excessive optimism? Exaggerations from politicians and media? We make do with what we got, i.e. equities, the last class of assets that can generate value? …

I have the impression that things have changed over last decade, and expectations of investors may have also be different.

“Normalized interest rates”, what do we mean?

Let’s have a look at last GFC in 2008, some thought we would have recovered interest rates and bond yields levels pre-crisis after couple of months or at maximum years. Some investors were more pessimistic and thought rates could stay low for longer. The disagreement was more around timing that around the levels. Are we not entering a “low forever” instead of a “low for long(er)”? Maybe…But some investors now play on the idea that bond yields will never rise again. Who knows? But it should not come soon for sure. When will we see treasury and government yields above inflation? It is a good question. A way to predict future and check market perception can be found in the futures. A 10Y-10Y treasury forward is supposed to give us the idea of what investors see the 10Y will be in 10 years. It gives a measure of expectations. When we compare the level in 2009 and now, we can see a huge difference, i.e. from 5%+ to 1,6%, lower than Fed’s inflation targets. They see rates low for longer. The rate expected 10 years ago for today was around 4,5% where the 10 years is around 0,6%. As always, futures reflect per definition the perception of the future based on today’s data. It may change. But it gives an indication that the “low for longer” vision is well anchored in our minds. The mood and expectations are slightly different today than it was after last GFC. And when you have a close look at bank valuations, they also reflect these low rates views. We know how banks benefit from rising interest rates with their ALM management. Negative interest rates are the gangrene for financial institutions for many obvious reasons. Rates will not be back to levels they had decades ago. But at least we all would prefer normal yield shape and slope/steepness (not inverted) and above zero percent (at least) for short-term and over-night rates.

The trick with equity indices

The current level of the S&P500, the most or one of the most performing indices today, is a bit confusing. It looks like the market is recovering fast and well. However, we should not forget that the weight of each company in the index can change depending on its market capitalization and that today the total proportion of tech companies is bigger than ever and over-weighted I would be tempted to say. It does not reflect the real state of the real economy. Indices can be tricky to analyze and truncate the picture. It looks nicer than it is, and it explain this “K” shape recovery. It also looks like the “smaller” listed companies’ outperformances have disappeared. It seems that Big has become better. The performances of big guys and FAGAN are the wood for the trees. This discrepancy is even more obvious when you look at small businesses and SME’s, in US and elsewhere. The credit risks related to smaller businesses is peaking up and unbalancing the Western economies. The spike of corporate bankruptcies has been more moderated than initially feared. However, I do believe that some smaller businesses will be hit by the length of the crisis. It seems so long to come back to normal that on the distance, companies will suffer and be at risk. 2021 will be bloodier than 2020. The access to credit for SME’s becomes a problem in the US. Politicians will have to intervene to make sure credit to SME’s are still “attractive” for investors. We all know the importance of smaller companies for the whole economy. They are the blood of capital systems. The fluidity of this blood should be a top priority for governments. They provide jobs and ensure the normal development of economies.

How will the future be in terms of interest rates?

No one could predict where we will be. But it looks that we will not reach former high levels for many reasons. We have a decline in economy vigor despite new technologies, GAFAN’s performances and despite the digitization of the world economy. The weight of global debts, especially of States after COVID crisis, mean that significant increase of interest rates seems unlikely and would completely kill some debtors. Banks are already facing huge provisions for bad debts. That is paradoxical: higher rates would help but in terms of credits would be counterproductive and damageable. The problem is to have inflation-adjusted rate around zero for the coming decade will inevitably force to readjust referential and to reconsider what we mean by “fair price” of financial assets. We will have to revisit of references, our benchmarks and adjust accordingly our investment strategies, as pension funds, for example, are doing now. Difficult to explain to our children that money has value and what normality should be. I keep thinking reading finance manuals in 10 to 15 years will be interesting to see how professors address and explain what we are currently facing and will have to stand for a while, I am afraid.

 

François Masquelier –SimplyTREASURY

 

Quotation : “As always, futures reflect per definition the perception of the future based on today’s data. It may change.”