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Normalized interest rates are the cure, not the problem

Central bankers would be wise to continue their interest rate hikes

By Martin Pelletier

Markets are rather fickle these days, reacting quickly and powerfully to any news. So far this year, the developments have predominantly been negative, so perhaps it isn’t surprising that we are off to the worst start in decades.

The problem, however, is that markets appear to be dominated by momentum traders, speculators and algorithms, which are combining to drive exaggerated daily moves, both up and down.

For example, over the past week, there was a large selloff of shorter duration segments such as energy and a rotation into longer duration areas like technology as speculators made their bets on red (inflation) or black (deflation). Highly torqued tech funds such as Cathie Wood’s ARK Innovation ETF rocketed 9.1 per cent last Tuesday while energy producers in the United States, as measured by the SPDR S&P Oil & Gas Exploration & Production ETF, fell 5.5 per cent.

Fundamentals, unfortunately, are getting thrown out with the bathwater as markets gyrate based on whether some moving average has been broken to the upside or downside or on what the latest tea leaves tell us about the U.S. Federal Reserve’s determination to raise rates, despite the tantrums of the QE addicts who continue to warn tightening could spark another financial crisis.

This leaves traditional investors and portfolio managers who buy and sell stocks and bonds scratching their heads as their extensive research on once-important things such as earnings and cash flow seems all for naught. It certainly feels that way these days, especially with steadfast 60/40 balanced portfolios down anywhere from 12 to 18 per cent this year, depending on the manager.

This is where it helps to take a step back, take a deep breath and ask ourselves if moving interest rates to 2.5 to three per cent is really the end of the world, especially if it helps bring down some of the inflationary pressures. Getting a yield of four to five per cent on your bonds, seven to 10 per cent on your equities and inflation back down to three or four per cent sounds like an attractive outcome, doesn’t it?

Meanwhile, the demand for services is so strong right now that it is impossible to get a passport on time, airlines are taking more than two weeks to find luggage, hotels are charging an arm and a leg for rooms and rental cars are few and far between. Does all of this sound like a prelude to a major recession?

Billionaire hedge-fund manager Bill Ackman offered some excellent insight on this debate recently on Twitter, arguing that inflation is a greater risk than high interest rates. Central bankers would be wise to take note and continue their rate hikes.

This is when it is important to break out nominal from real growth. For example, real economic growth will be difficult to achieve since nominal growth needs to be higher than the current inflation rate of 8.6 per cent. This comes to mind whenever I hear those touting the days of double-digit GIC rates without realizing that in real terms they were actually losing money given inflationary pressures were higher in the late ’70s and early 1980s.

The best way to end this stealth recession is to bring inflation down. If companies just hold fast with earnings growth, the potential for multiple expansion will return again.

“Stocks of high-quality businesses with long-term growth and pricing power look cheap,” Ackman said on Twitter. “Don’t forget that the stock market measures nominal business value. Inflation is hurting business and consumer confidence and slowing growth. Killing off inflation will save the economy in the longer term at the expense of some short-term pain.”

All of a sudden, those companies trading in the Russell 2000 at PE multiples currently below 2008 levels will look like a bargain. All of a sudden, financials such as banks making even greater profits on widening spreads look like a bargain. All of a sudden, oil companies discounting US$50 or US$60 oil in their valuations while generating enough cash flow to buy back their entire enterprise value in five to seven years look like a bargain. All of a sudden, being able to buy a bond with an interest rate of four to five per cent looks like a bargain.

The ones who suffer in such a transition are those dependent on cheap leverage to boost returns: think speculators in residential real estate, who need low interest rates to boost asset values. Or those who require an ultra-low cost of capital to fund “loss-leader” models while they chase scale and justify lofty forward valuations. Those who get their fix chasing daily momentum trends by betting on red or black would be in trouble, too.

Remember all this when opening your Q2 portfolio statements. Playing the long game means not allowing the near-term noise to rattle you: you have to stay the course as an investor, not devolve into gambling. Common sense always wins if given enough time.

Source: Financial Post