For much of the past two decades, inflation has been all but non-existent and interest rates generally have only gone down. Because of the shocks of the bursting internet bubble around 2000, the great recession in 2008-09, the sovereign debt crisis in 2011 and the global pandemic that started in earnest in 2020, not only have the world’s central bankers pushed rates lower, but they have also experimented with other forms of easing, including a super accommodating bid for various risk assets. Super low rates, accompanied by swollen central bank balance sheets over long periods of time, have been acceptable, given the nature of the banking crisis in 2008-09 and the pandemic, but these incredible shock absorbers for the system are far from conventional or normal. If you joined our industry in the past twenty or so years, which is the vast majority of those employed in financial services, you really haven’t known a world that resembles the realities of history and normal cycles. This is why it might not be your fault if you are unprepared for what is happening now, given the most formative lessons are typically learned through personal experience rather than reading about history. At the risk of showing our age, we have prepared a “Boomer’s Guide” to Dealing with an Increasing Interest Rate Environment. No cycle is precisely like the previous one, so this is not a perfect recipe to successfully navigate increased rates, but hopefully some of these thoughts will help us all accept, adjust, and be better prepared for what may come next:
- Genius effect. First let’s state the obvious to frame the conversation: when rates are super low, everyone is pushed into riskier assets because the world is starved for yield and opportunity. Pension funds, retirement accounts, and endowments all need to generate returns for their constituents to be able to pay their obligations and expenses. If there is a very limited yield because treasuries offer close to zero (or even negative in real terms), everyone becomes a “risk taker.” As an ever-increasing flow of money enters ever riskier assets, their prices go up, and investing seems easier and more fun. Pretty soon, everyone feels pretty darn smart.
- Trees don’t grow to the sky. Value investing has been disappointing for a very long time. Continued super low interest rates have contributed to what many believe is the end of bottom-up financial analysis where things like stability of earnings and cash flow, tangible book value, capital structure, margins, defensive moats and the like really mattered. Recently, growth and innovation were all that mattered, and multiples of revenues and size of addressable market have taken over as the accepted new normal. When we only rely on growth and momentum, and derive valuation merely by looking at the valuations of similar highly valued businesses, there will likely be a major day of reckoning when interest rates rise and the cost of risk rises with it. In fact, there can be multiple points of reckoning as valuations can adjust a number of times. Don’t take solace from where things were once valued and expect it is just a matter of time before we grow back to that level. At some point, financial or strategic value will provide a floor to prices and investors or strategics will act to take advantage of opportunity. Your opportunity is to see, analyze, anticipate, and appreciate that reality.
- Knowing the difference. Some riskier assets that rise in value are the product of brilliant ideas driven by creativity, spectacular execution and/or exceptional technological advances. These investments/companies are worthy of vastly elevated expectations and mind-bending valuations. Their scale becomes enormous and often they set the tone and direction for the next decade(s). With just a few incredible exceptions, they become profitable with strong margins and growth trajectories, and gain incredible market share in their respective domains. However, there are also a lot of wannabes. Investments/companies sometimes are valued purely on interesting ideas, too much readily available capital due to excess liquidity and often charismatic leaders who tell amazing stories. When rates keep going down, only the best investors can truly distinguish among these categories. It gets a lot easier to differentiate between the two types when rates are going up. Since we may be just at the beginning of this potential cycle, it is not too late to begin some soul searching regarding the basis for valuations and execute accordingly.
- Mistakes now go the wrong way. We all make mistakes. It goes with the territory. We don’t have a scientific study to point to but trust us: mistakes in a rising interest rate environment rarely result in pleasant “lucky” surprises. They also are more frequent, their ramifications are felt quicker, and reversing them is much harder. Unfortunately, the only thing you can do with this “nugget” of wisdom that has been dropped on our heads far too often is to be extra careful, overcommunicate, and accept that your first quick loss is often your best loss.
- Transitions hurt the most. Just like human beings, markets are most discombobulated during periods of uncertainty. If rates are stable and low, or even stable and high, we can all adjust to the rules of the game and decide our strategy and execute. It is those periods in between when we go from understanding our current reality to trying to figure out what’s next, that the wheels often fall off the cart. This is why the job of central bankers is so complicated and delicate. Managing fear, greed, logic, and expectations for the masses during transition periods is a painful art and since every cycle is truly different, there is no assured playbook to follow. These are often the most volatile and hence dangerous periods of market cycles. While they are so uncomfortable and it feels like these periods will never end, in our experience they are relatively short in duration, at least in hindsight. It just doesn’t feel that way when you are in them. Maintaining calm, keeping perspective and a firm hand on risk management are the keys to getting to the other side.
- Fixed Income is interesting again. Ok, fixed income is always interesting. However, when rates are low and spreads over treasuries are super tight, it is very hard to have a high allocation to this asset class due to return demands. Additionally, low interest rates make most fixed income products highly correlated, so it is much harder to differentiate yourself as an investor or manager of these assets. Once we get through the current transition period successfully, fixed income will regain its rightful long-term spot as a tremendous adder of value to a portfolio. As we help our clients differentiate the good, bad, and great within this vast market, the opportunity for Jefferies to be an even more important partner will increase. This is exciting.
- Corporate clients need to adjust. We have all been spoiled by low interest rates, but perhaps nobody more so than the CFO’s and CEO’s of the companies we serve. If the 10-year treasury increases a whopping 100 bps from 1.75% to 2.75%, it will not be the end of the world. We remind everyone that we have been so spoiled by super low rates for such a long period of time, that we have forgotten the reality of the cost of debt. Yes, rates will increase and most likely, spreads will widen. That said, those who are early to embrace the reality that the era of “free money” may be over and they now need to capitalize themselves in the real world will be the winners. Also, what looks like expensive money today may look like a deal of a lifetime tomorrow. The real question is: what are you going to do with the proceeds to add value for stakeholders? If we help our clients figure this out properly, once again we will be of greater value to our clients than when money was free.
- Fighting inflation is worth the battle. You cannot read about inflation in the history books and comprehend what it does to the fabric of society. Your purchasing power becomes less by the day, interest payments on mortgages and credit cards can skyrocket and the cost to finance the government increases, which means taxes ultimately go up to minimize the imbalances. It should come as no surprise that the ones who hurt the most from inflation are those who can least afford it: lower wage earners. One can easily believe that there is so much division in our country between the haves and the have-nots that it cannot get worse. As painful as this transition period and higher rates may be as we work to make sure inflation doesn’t get out of control, it is a very worthy objective for all of us, so we should be appreciative of a proactive and smart Fed and not be divisively resentful.
- Quality research and advice are more valuable. While super low rates cause everything in the world to correlate, a return to more normal interest rates means that unique ideas and insight are more valuable than ever. This should be very good news for all of us at Jefferies. We have ample capital, but we have never let that define us. We have worked long and hard to build true industry focused investment banking expertise and the highest quality global bottoms-up research effort. This, combined with the strength of our relationships with our clients who truly trust us, are all major assets that will define us during this next period. We have all the tools we need to be even more important than ever to, once again, help our clients through a potentially volatile period. We expect they know this, but we can never take it for granted.
- Our Jefferies home is strong. We have a lot of people at Jefferies who have never been through an increasing interest rate environment. Fortunately, we also have many who have. It isn’t a coincidence that we refinanced our long-term debt needs last year (and paid and fully expensed significant make-whole premiums to our bondholder-partners). It isn’t by accident that we have record liquidity and financial firepower, as evidenced by our recent upgrades by the rating agencies. It also shouldn’t be lost on any of us that our human capital at Jefferies has never been more impressive throughout every aspect of our firm and on a global scale. Our brand, market share, client base, and recognition within our industry should make every one of us proud. Finally, all of us at Jefferies know that we will always stay humble and devoid of arrogance, constantly prioritize our clients, treat each other with respect and inclusivity, and always be honest and transparent. If we could pick one recipe for dealing with an increasing interest rate environment, these last ingredients would be perfect.
With great appreciation and a little more interest earned in our checking accounts,
Rich and Brian