Higher Risk-Free Rates Are Crushing Stocks

​Much of the talk in financial markets over the past year or so has been focused on inflation and rising interest rates. As prices rise, central banks raise interest rates to squeeze consumer demand and bring down inflation. But so far it hasn’t worked. In the US, core inflation which strips out food and energy prices, unexpectedly rose in August reflecting robust consumer demand. 

US CPI is now virtually unchanged from last month, falling only .1% to 8.4%. In response, the Dow Jones fell by 4% and bond yields soared. Faced with the reality of sticky inflation, investors are pricing in more rate hikes over the coming months by central banks who will perhaps start to tighten monetary conditions further still. Hopes for a 'Powell Pivot' are fading.
 
When a central bank increases short-term interest rates, the so-called ‘risk-free’ rate associated with government bonds also rises. This is the fixed income return investors receive from lending to the government. For much of the past decade after the financial crisis, the risk-free rate as measured by a 3 month treasury bill hovered around 0%, pinned down by central banks' loose monetary policies. In response to lower yielding bonds, investors shifted in droves towards stocks and risk assets including crypto.
 
In the period between 2009-2021, lower rates and the glut in the money supply from quantitative easing drove stock valuations to all-time highs. While US GDP grew by just 2% per annum, stock markets boomed.
 
But that’s all changing now due to inflation. Tighter monetary policy by central banks is pushing up short-term interest rates in the fight against rising prices. In the past year the yield on the 3 month government bond has increased from 0% to 2.75%. Longer term government bond yields are also rising. The 10 year US treasury bond currently yields 3.43% compared to 1.35% a year ago. Safer assets are now making a noticeable comeback from the lows of the previous economic cycle, slowly closing the gap on returns provided by stocks. 
 
Since inflation began to rear its ugly head last year, the S&P and the Nasdaq have fallen over 20% from their previous highs. Equities are currently in bear market territory.
 
How further can stocks fall? Since the 1940’s, studies show that on average stocks fall another 13% after crossing the initial 20% threshold, usually bottoming out after six to nine months. Based on these stats, stocks have another leg down to go before levelling off.
 
While it’s unlikely interest rates will jump as high as 20% as they did in 1980, a view of the past may give a helpful glimpse of the journey that lies ahead. As interest rates steadily rose in the 1970’s, a period like today consisting of energy shocks, higher inflation and declining growth, markets fell by almost 40% between 1973-74 and again by 30% in 1981. It wasn’t until inflation and interest rates started to fall in 1983 that stocks began to recover. Given that today’s central banks have only just started quantitative tightening, and bearing in mind that inflation remains stubbornly high, equities are expected to continue their downwards trend in the near term. As Mark Twain once said, "History doesn't repeat itself but it often rhymes".
 
The effects of higher rates on corporate bonds is also concerning. Notwithstanding the probability that economic conditions could soon worsen, the ability to issue new debt at reasonable rates will be a major challenge for many corporations.
 
As mentioned in this blog previously, the level of debt in the global economy of $226 trillion now exceeds anything seen in recorded history. Since the financial crisis alone less than fifteen years ago, non-bank corporate debt in the US has risen by 60%. As a proportion of US GDP, corporate debt currently stands at approximately 105%. Put another way, for every $1 earned, $1.05 is owed in debt. 
 
Last week on September 17th, the Financial Times published an article called ‘The Debt Monsters.’ The article lists some of the world’s most indebted companies including ASDA, Iceland, Metro Bank, AMC Entertainment, and Irish-owned Digicel.
 
Digicel, which is located in Jamaica and has debts denominated in dollars, is offering interest rates on its bonds roughly 2,000 basis points above government treasuries. In short, due to over-indebtedness, a strong dollar, and a rising risk-free rate, Digicel bondholders are being offered a 20% premium on their bonds to invest in Digicel compared to US treasuries. Such high rates seem unsustainable.
 
While Digicel is an extreme case, most junk bonds with 10 year durations are yielding between 8%-10%, up from 5% a year ago. As the credit spread (difference) between the risk-free rate and corporate bond yields narrows, corporate bonds must continue to rise higher to attract investors. As one in five large US corporations is categorised as a ‘Zombie’ firm with a junk bond credit rating, it doesn't bode well for a corporate sector languishing in debt.

Indeed, assuming an economic slowdown in the US occurs, many corporations could be locked out of bond markets from prohibitively high costs of borrowing. A sell-off in corporate bonds by nervous investors sends bond yields soaring while bond prices fall, badly effecting both the issuer and the holder. Over-leveraged bondholders facing margin calls will be particularly hit, as will corporations facing bankruptcy. The safety net of rolling over debt at cheap rates is no longer an option.
 
Last week FedEX CEO, Raj Subramaniam, announced that due to worsening global economic conditions, FedEX missed its quarterly targets for 2022. The firm has since put a freeze on recruitment and withdrew from providing projections for the rest of the year. FedEx shares tumbled by 21.4% shortly after the announcement. As a global shipments company, FedEx is an excellent barometer of consumer sentiment and business activity around the world.
 
Amid recession fears, the traditional response from central banks is to cut interest rates when the economy hits choppy waters. But given how far inflation is from their 2% target, interest rates are expected to continue rising even into a recession. Barring an unexpected improvement in geopolitics, the outlook for stocks is very much tilted to the downside.