The Impact of Higher For Longer

Telemus Weekly Market Review September 18th - September 22nd, 2023

This week the Federal Reserve made the decision to hold interest rates steady. However, their forecasts along with rhetoric out of Fed Chairman Jerome Powell indicated that they expect to hold rates at an elevated level for some time. In fact, projections out of members of the Fed’s Federal Open Market Committee indicated that it may be until at least 2026 before interest rates fall to a level that is no longer deemed to be restrictive on economic growth. We believe a “higher for longer” policy out of the Fed is likely to be more impactful than what is currently perceived in parts of the market. In our view, the impact will be more pronounced in select asset classes and sectors of the market. 

Take for example the corporate bond market. Heading into the rate hiking cycle that began eighteen months ago, corporate management teams had prudently refinanced their bonds at lower rates and pushed out the time to maturity. Therefore, despite the Fed hiking rates over five percentage points, companies with corporate bond debt have experienced little to no impact on their borrowing costs. However, the longer rates stay elevated, the more likely they will have some maturities coming due that will force them to refinance at these higher levels. When we look more specifically and compare investment grade and high yield bonds, high yield issuers face greater risk. The reason being is that investors in high yield bonds prefer to lend out over a shorter time to maturity. Given this, the high yield market will see maturities come due quicker and therefore are likely to be more impacted by a higher for longer interest rate environment. 

The real estate market faces a similar impact from higher for longer interest rates. As an asset class, the use of debt is more prevalent among real estate owners. In today’s market, on average real estate assets are throwing off cash flow yields that aren’t that differentiated from yields offered by the bond market. This reflects expectations for future rent growth and, in our view, some expectations that interest rates will drop in subsequent years. Should the direction of rates not fall over the next year or two, then valuations on some real estate assets may need to adjust to account for higher borrowing costs. Given the diverse range of valuations across the real estate market today, we would expect a higher for longer interest rate regime to impact some sectors and assets more than others.   

A situation where interest rates are higher for longer will also lead to a renewed assessment of expected returns across different asset classes. For example, if bonds are going to offer an attractive mid-single digit yield, then long-term high-single digit equity returns look a little less exciting given their greater level of risk. When we look back at past environments where interest rates have been at levels similar to today, stocks have tended to trade at price-to-earnings multiples in the 15-17x range. Currently the S&P 500’s valuation is roughly 20x earnings. This would indicate that stock prices may need to adjust lower to reflect interest rates that will remain higher for longer. While this expectation is not unrealistic, we note that the average stock within the S&P 500 trades at a multiple closer to 17x earnings, and thus the impact may be more pronounced on parts of the equity market that currently trade at more elevated levels. 

Lastly, the U.S. dollar has been elevated relative to other global currencies given higher relative interest rates offered in the United States. We’ve begun to see some emerging market economies, including China, begin to cut interest rates. Should softer economic conditions in other parts of the globe lead more developed economies to cut interest rates, the U.S. dollar is likely to remain attractive to oversees investors given the higher for longer interest rate picture. Therefore, in a higher for longer regime, we’d expect the dollar maintain its strength versus other global currencies. 

As we consider these pieces in aggregate, higher for longer is not necessarily a negative for investors. Should the Fed’s forecasts prove reasonably accurate, and as investors begin to accept that rates will remain higher for longer, then asset prices will need to reflect this. In fact, we some repricing occur following the Fed’s meeting this past week, as the S&P 500 ended up retracing -2.9% on the week. In our view, emphasizing assets not reliant on debt markets and those with valuations that reflect higher for longer interest rates will likely prove attractive in such an environment. 

All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable, however Telemus Capital cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS. Investment decisions should always be made based on the client's specific financial needs, goals and objectives, time horizon and risk tolerance. Current and future portfolio holdings are subject to risk. Risks may include interest-rate risk, market risk, inflation risk, deflation risk, currency risk, reinvestment risk, business risk, liquidity risk, financial risk, and cybersecurity risk. These risks are more fully described in Telemus Capital's Firm Brochure (Part 2A of Form ADV), which is available upon request. Telemus Capital does not guarantee the results of any investments. Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, and may lose value. Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products.  The S&P 500 index includes 500 leading companies in the US and is widely regarded as the best single gauge of large-cap US equities.

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