Without doubt, we can draw some lessons from previous cycles; most notably, that when interest rates rise, this typically spells trouble for economies and markets.
The lags between policy changes and the economic effects are uncertain, but one of the ways in which higher interest rates bite is by exposing recklessness and speculation. This leads to a cooling of animal spirits, lower market valuations, and slower economic activity overall.
First to fall were growth stocks and cryptocurrencies, then came the UK’s bond crisis in 2022.1 The most recent victim of higher rates was the former darling of the tech start-up industry, Silicon Valley Bank. Falling deposits forced the bank to crystallize the losses on its bond portfolio and, as I write, uncertainty over bank funding costs is affecting both the US and European banking sectors.
What’s also a common occurrence as rates rise is that seemingly idiosyncratic challenges facing a particular company can cause a domino effect to other companies as investors take a closer look at the risks across their portfolios. For example, the troubles at Silicon Valley Bank led to a reassessment of risk across US regional banks and beyond (i.e., Credit Suisse). The common link: these banks were seeing falling deposits.
These occurrences evoke memories of 2007 and 2008—although, compared to back then, large banks are now more conservative and capital is considerably higher. Nevertheless, we see all of this as evidence that higher interest rates are leading to tighter credit conditions and that strains on the US regional banks are likely to continue.
As a consequence, our multi-asset team favors government bonds and higher-quality credit as we expect the US economy to slow and move into recession later this year. We remain cautious on equities; while valuations have improved, the cyclical clouds are darkening.
To the extent that we can draw historical parallels, I continue to think that the 2000-2003 roadmap is useful.
Back then, we had a bubble in growth stocks pricked by higher interest rates. The first phase of the bear market (2000 to 2001) entailed a de-rating2 across markets as valuations adjusted to higher rates. The second and final phase in 2002 was more company-specific, with fraud at Enron, for example, causing uncertainty about the level of corporate earnings and further weakness in markets. As it’s often said: as the tide goes out, we find out who is not wearing any shorts.
The current market environment reminds me of the summer of 2002 and suggests there’s a bit more work to do on corporate-earnings expectations and equity valuations; but remember that some de-rating has already occurred.
But we also have to think about how each cycle is different. I’ve talked a lot about regime change and how we should think about what we did in the 2010s and do the opposite.
One challenge is that, in the 26 years I’ve been analyzing markets, I haven’t seen such a persistent problem with inflation and the Federal Reserve (Fed) may not be able to pivot policy as quickly as the market is now pricing. On this front, signs of softening in the US labor market would reassure investors that the Fed is close to getting its job done and would remove a significant obstacle for markets.
