At the time of writing, the “mother of all equity indices,” the S&P 500 Index, is down a significant 4% from its early April peak. This downturn is partly driven by escalating tensions in the Middle East.
Of course, this in itself isn’t something to cheer about. However, there’s another critical reason why stock prices are under pressure. Interest rates are inching closer to 5%, entering what many consider the danger zone.
Oops
After three disappointing inflation reports, the markets have abandoned hope for three rate cuts. Add to that the strong job growth figures and retail sales exceeding expectations, and you’ll hear forecasts of interest rates surpassing 6% left and right.
In financial markets, one should never dismiss any scenario outright. Who could have predicted nearly four years ago that oil prices would close at almost 38 US dollars in the negative? Not me. Yet, a 6% interest rate inevitably spells recession. We’ve recently seen several examples suggesting that at 5%, things start to squeak and creak from all sides.
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Last March, the U.S. 2-year Treasury yield exceeded 5% for the first time since 2007. The immediate consequence was a regional banking crisis, with just five banks going under. However, those banks represented the largest amount of assets involved in such failures, exceeding 500 billion dollars.
Mistake, thanks!
In September 2022, then-Prime Minister Liz Truss and her Chancellor of the Exchequer unveiled a ‘brilliant’ plan to announce tax cuts (for the wealthy, by the way) without any offsetting measures elsewhere in the budget. This unfunded tax cut led to a spike in the 2-year UK government bond yield to nearly 5%. Eventually, the Bank of England had to intervene to offset the government’s amateurism. With several significant purchasing programs, which is what central banks do nowadays when interest rates are too high, the spike in rates was curbed. But by then, the British pension and insurance sector was already drowning, unable to cope with the rapid rise in rates.
And then there’s Italy, where the European Central Bank has kept interest rates artificially low for years. It’s no coincidence that the Italian 10-year government bond yield climbed to 4.98% last October, the highest level since 2012, when Italy narrowly escaped being forced out of the Eurozone.
Give it time
There’s one factor that might allow economies to handle a 5% interest rate over time, and that is time itself. Time gives all parties a chance to adjust to the new situation. However, with sky-high debt ratios, it’s likely that some will fail. A common mistake, in my view, is to point out that, for example, the United States now pays the same amount of interest - as a percentage of GDP - as it did in the 1990s.
That’s true, but back then, there was also less spending on healthcare, social services, and other mandatory government expenses. Moreover, the behavior of central banks since the Great Financial Crisis indicates they prefer not to wait and see if bankruptcies and potential systemic risks materialize. And then, as often, the solution is lower interest rates.
Jeroen Blokland, with his deep expertise in multi-asset investment strategies and keen insights into economic trends, challenges us to ponder the true nature of growth and its implications. His weekly analyses, drawing from his extensive experience at Robeco and through his innovative platforms, urge us to consider whether our collective growth ambition aligns with the realities of our time and the planet.