Rethinking Our Assumptions: Preparing for Rising Interest Rates
My entire career in finance was dominated by one trend. Long-term interest rates declined. Of course there were brief periods when they rose, but the trend was sharply downward for over three full decades. Shortly after I ventured into the business as a lowly telecom analyst, long-term interest rates peaked at about 16%. In the earliest days of my career, I got a glimpse at the pressures created by high and rising interest rates, but those pressures began to dissipate in the early 1980s. While I bounced around from job to job over the next thirty years, interest rates kept falling and bottomed out at roughly 2% as I retired.
I was extraordinarily lucky because declining interest rates fueled the economy and the money management business throughout my working career. Sure there were some nasty hiccups such as the 1987 crash, the demise of Long Term Capital (a hedge fund), and the credit crisis. However, the financial wind was at my back for over a quarter century. At some point the wind will change direction, and when it does virtually no one in the money management business will have actual experience in managing financial assets in rising interest rate environment. The seasoned professionals of the 1970s have, for the most part, retired.
While almost everyone in the business knows that rates will rise at some point, they’re ill-equipped to build portfolios and set asset allocations for this scenario. Of course when you turn to the experts on Wall Street, they routinely churn out advice that pushes investors into alternative investments purportedly to generate higher returns and control risk as interest rates rise. Besides lacking experience, these folks have massive conflicts of interest. By pushing their clients into alternatives, they’ll be lining their pockets with substantial management fees whether their advice pans out or not.
Alternative investments are hugely dependent on interest rates and credit. Private equity was, after all, previously known as leveraged buyouts, and a substantial part of its historic returns came from being able to borrow cheaply and then refinance as interest rates declined. Real estate investments benefited from the same credit conditions. And hedge funds were able to borrow in order to leverage their portfolios, which enhanced their returns. When interest rates rise, the alternative managers are going to have to adjust their business models.
I’m not predicting that rising rates will be an absolute disaster for alternative investors. However, I’m very certain that they will face challenges because high fees and too much institutional capital are already weighing on their potential investment returns. Let’s face it, equity investors and public companies will also have to adjust to rising interest rates. The valuation of stocks and the management of corporate balance sheets will present challenges when interest rates rise for a sustained period of time.
So what’s an investor to do? Be cautious. While uncertainty about the future is always with us, a sea change in interest rates could be particularly unsettling. The last time interest rates rose for a lengthy period in the late 1960s and 1970s, investing was particularly daunting. I wouldn’t make big changes in allocations, because predictions about how different asset classes will behave over the next 5 to 10 years probably have a wider than usual range of potential outcomes. I’d be reluctant to tie up too much capital in long-term commitments, such as private equity, because I’d want to have capital available to invest as interest rates rise and create opportunities.
For example, if interest rates were to rise quickly I’d want to have the opportunity to buy bonds, which for the first time in a long time might finally produce reasonable levels of income. Or, if the stock market were to swoon in the face of rising interest rates, I’d want to be able to pick additional exposure to equities. The point is that I wouldn’t want to have all of my capital tied up. Stated differently, this might be a time to sit tight and keep more cash on hand.