To Raise Or To Cut, That Is The Question

On June 14^th, the US Federal Reserve finally paused its interest rate hikes but remained hawkish despite clearly improving inflation numbers. The message was confusing, with Chairman Powell, the messenger, sounding confused. The impression was that he was blowing hot and cold in equal measure. But his central tenet was “as long as it takes”.

A few days later the scene repeated itself as the European Central Bank raised rates while explaining that “inflation is expected to be too high for too long”.

Tight labour markets, especially in the US, have been the culprit of persistently high core inflation in services. Nonetheless, and to add to the confusion, the US financial services industry has shed tens of thousands of jobs as they describe the employment situation as the most sluggish since the global financial crisis of 2008.

Credit markets, such as Collateralized Loan Obligations, the junk bond market, as well as banking activity in the US have all shown signs of stress and deteriorating liquidity. Defaults in junk loans have also risen sharply following the aggressive rate increases introduced by the Federal Reserve. This further pushes up the costs to borrowers and squeezes their margins and profits, as it places them on the defensive, eager to make yields attractive to new lenders. This is a typical knock-on effect of the pullback in banking loans being filled by shadow banks and non-mainstream lending institutions. It is also the result of the large bank failures experienced in the spring of this year.

This is particularly relevant for Quality Growth investors for whom the absence or quasi-absence of net corporate debt is a cornerstone of the true Quality Growth investment philosophy and rarely has this been as important as during this period of rising interest rates. The defensive nature of such Quality Growth investments coupled with their growth outlook and returns on invested capital (and a number of other crucial attributes) have been clearly visible in the share price returns of these companies throughout the year 2023. Largely unencumbered by the rising cost of money, such businesses have been able to fulfil, indeed often supersede, quality characteristics and growth expectations in what is a challenging environment to the average business.

That is a key difference to the average value investment portfolio where the absence or quasi-absence of net debt is no priority. Such a portfolio might seem superficially attractive through a low price-to-earnings ratio. In reality, this ratio is low for multiple reasons but nonetheless risks giving value investors a false sense of security. Defaults in credit markets are expected to continue for the foreseeable future.

China, meanwhile, cut its key lending facility interest rates as economic activity remains extremely disappointing. The differing approaches to the ongoing combat against inflation have become starker than in previous months when the rate was universally on an upward trend. Inflation rates and the components that feed into them vary, sometimes strongly, from one economy to another, and the same is true for inflationary expectations. Contrary to last year, this situation renders monetary policy even more challenging.

All eyes are now on central banks. The “clash of the titans” between fixed income markets on the one hand and central banks, accompanied by vociferous media tones, on the other continues unabated. Bond prices have recently become exceptionally volatile and so-called risk-free issuers potentially fragile, especially those of US Treasuries. This has spawned a discussion about the real level of risk associated with the concept of lending to the US government or, for that matter, many other western governments.

The most recent figure for the US budget deficit, for instance, is a staggering 8.25 per cent. The Fed’s aggressive tightening policy has put an end, for now, to distributions made by it to the Treasury. That the external value of the US currency remains stubbornly low is clearly linked to the budget deficit, as it always was.

Quantitative Tightening is set to continue, despite the removal of the debt ceiling that could result in a further liquidity drain of massive proportions as the Treasury resumes borrowing and lenders/investors are drawn from banking reserves. Although the worst-case scenario, it is legitimate to ask whether this will indeed hit liquidity and what it could do the banking system.

Meanwhile, the credit-to-GDP ratio, an early indicator of financial fragility, across the western world has exploded, according to the Financial Times. This degree of debt is not sustainable at these levels of interest rates. Although it is conceivable that a reduction of 1.5 to 3 percentage points is eventually on the cards and would help all borrowers, both private and public, it goes against mainstream predictions of interest rates (and inflation) destined to remain higher for longer.

Yet despite all the uncertainty and negative sentiment, share prices have risen in developed markets during this difficult year. Pessimists are quick to argue that price rises have been limited to a small number of hyped-up stocks relating to technology and, in particular, to those involved in Artificial Intelligence. These same pessimists also argue, surprisingly, that both the US and Europe will enter recession (or have already done so) as the year unfolds; and that this will erode the prices of shares with every additional piece of bad news; and yet the pessimists ignore that stock markets have strongly rallied back into bull market territory since the lows established in October 2022.

Optimists take a different view. They concluded long ago that the role of stock markets is to look ahead, rather than react to news and events. To them, last year’s bear market will have suggested, rightly or wrongly, that western economies are set to fall into recession (which has mildly occurred in certain important markets and may be followed by other economies). The discussion rages as to whether bear markets sometimes make prediction mistakes. To optimists and Quality Growth investors, this macro discussion is not relevant to the forensic work carried out when assessing whether a Quality Growth business fulfils their sacred Ten Golden Rules.

Yet the key question centres on the extent to which interest rates and bond yields need to rise; or whether the bulk of tightening has run its course; or whether leading central banks have hit the last lap and will, sooner than later, emulate the Chinese central bank and embark on monetary loosening once again.

This narrative is set to continue beyond today’s longest day. But the Quality Growth investor’s central principle is clear. It is preferable to be bailed out by a Quality Growth business over the long term than bailed in through a haircut to bondholders.

P. Seilern

30 June 2023

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