Interest rates are increasing at pace and will show no signs of slowing over the medium and long term, according to Florian Ielpo, head of macro and multi asset at Lombard Odier Investment Managers.
“The biggest mistake we could make now is to expect that rates will fall back in the US in no time because a recession will be here,” he said.
Higher rates are a structural phenomenon, one which is important to understand to be able to make more conscious investment decisions.
“To allow better predictions of the future market performance we need to look at interest rates, because they are very much likely to shape the returns of our pension schemes and of the 60/40 portfolio,” said Ielpo.
The widely-adopted balanced portfolio, including a mix of 60% equities and 40% bonds, has historically underperformed in high-rate conditions, as happened in the 1970s.
“Whether UK rates will be 4.5% or higher does make a great difference to investors. Although we may not be able to anticipate the peak, what we can do is monitor what drives rates higher.”
Below, he identified three key drivers, the first being that in the mid-term, higher rates are simply a necessity to combat inflation.
“This is especially true in the UK and the US, where the phenomenon of high inflation is currently localised,” said Ielpo.
In 2020 to 2021, the UK and the US have had a high deficit to GDP ratio, which drove inflation expectations higher than elsewhere, such as China and Switzerland, where spending has been limited.
“Understanding this means also understanding that inflation is driven by demand, not supply, as the Fed has made clear multiple times. And the only solution in the cookbook to demand-driven inflation is raising rates and pushing the economy into a recession.”
Looking at the longer term, the shrinking savings-to-investments ratio will give the market no respite, said Ielpo.
“Interest rates represent the cost of money, or the price at which we borrow money and we lend our savings to companies and governments that are willing to deploy it in investment projects. So interest rates are a way to bring balance between savings and investments,” he explained.
When you have high savings and low investments money is cheap, like it was in the past 10 years. With high investments and low savings rates, demand for money is high and supply is limited.
This second scenario is where we find ourselves at the moment and we will probably be stuck in for a while, Ielpo predicted; and the reason is two-fold.
He said two trends going forward that will keep money demand high and savings low were the energy transition and the ageing population.
“We calculated that $5.5trn per year will be necessary to fund the energy transition, leading to higher investments and even higher demand for money. We think investments will outmatch savings by 2%, pushing real rates higher.”
But the demographic of the Western world will also be a significant contributor.
“When you're young, you're saving money and when you're old, you're spending that money. When you have fewer young people than old people, progressively savings are drained from the economy because you need to spend them to survive. We have seen this is countries such as Finland and Italy, it’s a natural phenomenon.”
When it comes to investing, savers will need to reconsider their approach to diversification, as well as becoming more flexible with the assets they own, but should not avoid using ultra-low assets such as cash.
“There’s an extreme amount of uncertainty for which we need to be extremely defensive. At Lombard Odier, in our All Roads investment solutions we are currently 75% cash,” said Ielpo.
This was echoed by Ruffer Investment Company managers Duncan MacInnes and Jasmine Yeo yesterday, who said in the firm’s financial report that an allocation to cash was an “underrated decision”.
“It provides the certainty of a slow erosion by inflation, but it also gives you the option value of being able to move quickly. This is clearly reflected in our portfolio construction,” they said.