The past four decades have been marked by declining interest rates that ultimately landed at zero and stayed there for more than a decade. The decreasing cost of debt helped shape markets and investor behavior. But when the Federal Reserve raised rates post pandemic, it signaled a significant change in the marketplace, one that should spur a shift in how investors approach investing.
“Declining interest rates and ultra-cheap debt was the tide that lifted all boats,” says Paul Bodnar, Chief Investment Officer and Partner at CM Wealth Advisors. “Fed policy supported the markets. Investors could invest in equities and rely on the Fed to support markets at any sign of trouble — everything worked. However, the return of a cost of money and, more importantly, the threat of inflation limiting fiscal and monetary responses have established a new regime for investing.”
Smart Business spoke with Bodnar about how the conditions in today’s market should prompt investors to recalibrate their approach.
How will this reality impact the market?
We expect greater volatility in markets with longer recoveries along with a wider divergence in returns between asset classes and within them. Investors are used to the Fed responding quickly to economic softening and any weakness in the equity or fixed income market. That changed in 2020. Inflationary pressures from tightened labor markets, reshoring and other factors limit the response of the Fed and other central bankers. Fiscal policy responses face the same issues plus constraints from national debt levels that finally seem to be a real concern.
Until recently, Fed policy and cheap debt drove asset prices higher somewhat indiscriminately. In stocks, passive ETFs where investors essentially own the market, both good and bad companies did well. We expect this approach will be a bit more challenging going forward. For example, weaker companies that were propped up with inexpensive capital will find it increasingly difficult to stay afloat. Inefficiently allocating capital will get punished. We can see this real-time in some Chinese markets.
What should investors know?
Strategies that worked well in an ultra-low interest rate environment are unlikely to deliver the same results going forward. We see active management within asset classes as increasingly important. For example, stock picking in equities versus owning an index ETF is more attractive today. Greater divergence between company growth rates, margins and the impact of investment in areas like AI will create winners and losers.
Volatility can create opportunities for returns in asset classes that were previously unattractive. The zero-rate environment drove most people to equities because there was no alternative to achieve return targets. That is not true today. Investors can and should take advantage of opportunities to diversify their portfolios while maintaining long-term return targets.
In fixed income, where we had the two worst years of performance since 1840, there are unique opportunities in areas like structured credit and real estate debt. Regional banks were the traditional lenders in real estate, and they’ve had to pull out of the market. The dearth of capital available in real estate has created the opportunity to earn outsized returns. In private markets, we are seeing opportunities to generate mid-teens IRRs in senior real estate credit.
What’s the best approach?
Consult with your investment adviser. At a minimum, investors need to review their long-term investment strategy and evaluate their portfolio’s risk/return tradeoff. Look to take advantage of opportunities created by tight liquidity and volatile markets.
While many investment advisers are new to strategies in alternatives and are accustomed to passively investing client portfolios, there are advisers with decades of experience. It’s important for an investor to diligence the adviser. Adding alternatives and identifying tactical investments to include in a portfolio is not simple and takes significant experience. Experienced investment advisers can identify the investments with the greatest potential to outperform. Unlike most products, the best-known names are often not the best performers but merely the best salesmen.
