Compared to six months ago, the current state of the markets feels different. Investors who anticipated two or even three rate cuts this year are now adjusting to the possibility that the Federal Reserve may not be in any rush at all. This is a much quieter and more unsettling possibility. The cuts might eventually appear. However, the certainty has vanished. Furthermore, a lack of certainty carries weight in finance.
At the meeting in March, Jerome Powell made no dramatic remarks. Seldom does he. However, the tone changed in some way. If inflation doesn’t behave, he hinted that rates might go up rather than down. Even though it was a small admission, it was more difficult to accept than anticipated. Like a weather forecast that abruptly mentioned a storm for which no one had prepared, traders read it.
Every weekday morning in Manhattan’s financial district, the same people can be seen staring at phones, sipping coffee, and wearing earbuds. However, the discourse has shifted. Speculative tech bets are less common; instead, yield, duration, and which industries withstand high borrowing costs are discussed more. If it can be called optimism at all, it’s a slower, more circumspect kind.
The information speaks for itself. Since late 2021, central banks have raised rates by about 400 basis points in advanced economies and about 650 in emerging markets. The majority of economies fared better than anticipated in absorbing the shock. However, there are visible fissures beneath the surface. Smaller businesses in both wealthy and developing nations hardly have enough money to pay interest, according to the IMF. The market for leveraged loans is seeing an increase in defaults. Additionally, corporate debt totaling over $5.5 trillion is about to mature; this wall doesn’t care what investors hope for.
The strain is most apparent in real estate. Developers in Germany are discreetly declaring bankruptcy. The office market in London is facing unprecedented vacancy rates in thirty years. Strangely, a large portion of Sweden’s property debt is short-term, making it a bit of a canary in the coal mine. The property group SBB, which owns schools and hospitals, is rushing to improve its balance sheet. It’s difficult not to wonder how much of this suffering has been priced in elsewhere as you watch this play out.
China falls into a different category of concern. Property accounts for about 25% of the Chinese economy, so Evergrande’s $300 billion debt load and Country Garden’s problems are not local issues. The ripples spread everywhere when that sways. Chinese real estate was identified by BofA’s survey of fund managers as the most likely cause of a global credit event. That’s not a silent worry. More prominent headlines simply overshadow it.
Some investors are making intriguing adjustments. ETFs that provide diversified exposure to energy infrastructure and real estate, which typically have pricing power during periods of inflation, such as VNQI and MLPX, have garnered attention. The data center REIT Equinix is frequently mentioned because of its stable cash flow and long-term contracts. These aren’t any dramatic wagers. They have patience.
Over the next five years, analysts now predict that rates will settle between 3% and 4%, progressively declining as inflation declines. Perhaps. The persistence of this cycle seems to be underestimated by markets. Last year, everyone anticipated a pivot, but it never materialized. Next year, it might not come either. And that might be the true story that investors are gradually coming to terms with, more so than any particular data point.
