LAST WORD Base rates jumping
Andrew Davis @andy_davis01
“
In February 2023 the Bank of England increased the base rate to 4%, which compares with just 0.1% just over a year earlier. That same month, the US Fed funds rate rose to 4.5-4.75%, compared with around zero in the first quarter of 2022, and the ECB raised its three key rates again. Base rates directly influence the yields
on government bonds, which in effect provide the yardstick by which most other assets are valued. They play a foundational role in the financial world. The change in direction therefore has major implications across the board and will touch every part of the financial system, affecting organisations of all sorts. It would be impossible to produce a
comprehensive list of the changes that rising base rates will bring in their wake, but we can readily identify some of them with reasonable confidence. For more than 30 years, a steady
decline in global interest rates – sometimes blamed on a glut of savings, especially in Asia and the Middle East – has caused a worsening headache for so- called final salary pension schemes in developed economies. These schemes pay their members a guaranteed retirement income funded largely from the yield schemes receive on their bond investments. As bond yields fell, deficits opened up between the income the schemes were forecast to receive and the amounts they would have to pay out in future pensions. These deficits are calculated using government bond yields among other inputs, so falling yields mean bigger deficits and rising yields tend to close the gap. As interest rates have headed back up over the past year or so, the deficits on
70
AFTER ALMOST 14 YEARS OF ULTRA-LOW INTEREST RATES, THE TIDE HAS TURNED AND THEY ARE ONCE AGAIN ON A FIRMLY UPWARD PATH, FUNDAMENTALLY ALTERING THE GLOBAL FINANCIAL LANDSCAPE IN WHICH INVESTORS OPERATE
these pension schemes have in many cases disappeared, putting the pensions of millions of workers on a much sounder footing. This will come as a huge relief to many older workers who are members of these schemes, but will offer cold comfort to their younger colleagues. Faced with yawning deficits in their final salary pension schemes over the past two decades, caused by ultra-low interest rates, most companies closed them to new members. This summarily denied younger workers the safety in retirement that their parents’ generation was guaranteed. Will these ‘gold-plated pensions’ make a comeback now that rates are returning to more normal levels? Don’t hold your breath.
High interest rates will
spell trouble for companies that depend on cheap borrowing to survive
Back in the days when base rates were
well above zero and government bonds offered meaningful income, many investors favoured the so-called balanced portfolio, which combined equities and bonds in a classic 60/40 blend. The theory was that the two assets tended to balance each other out, with bonds doing well when equities struggled and vice versa. This worked especially well when bond yields were solidly positive because investors could get paid a decent income for holding bonds, while also benefiting from the ‘insurance’ they offered against falling equity markets. But with bond yields at zero or lower, the theory no longer worked as well, and bonds lost one of their key attractions as an investment – steady income. Now that yields are
rising again, it is possible the 60/40 balanced portfolio will stage a comeback. A third inevitable effect of higher interest
rates is that unicorns – privately-owned start-ups that achieve a valuation of US$1bn or more – will become rarer. These formerly mythical beasts proliferated during the era of ultra-low rates as investors took on more risk in search of higher returns. But with rates rising and capital therefore more costly, investors will be more careful about how they allocate it, in particular becoming choosier about funding risky, speculative ventures at extraordinary valuations. Achieving unicorn status is likely to get a lot harder, and entrepreneurs that have big dreams but burn through cash year after year will find the going extremely tough. Does the same go for cryptocurrencies? I
suspect not. The urge to speculate will never die and crypto’s one undoubted strength is as a vehicle for unfettered 24/7 speculation. Finally, and most obviously, high interest
rates will spell trouble for companies that depend on cheap borrowing to survive. For years, there have been complaints that ultra-low interest rates were artificially prolonging the life of over-indebted ‘zombie’ companies and so blocking the fundamental capitalist process of creative destruction, whereby resources are released from failed companies for use by others that can generate higher returns from them. Rising rates are likely to speed the demise of the zombies and create new opportunities for others. Messy and painful though it is, creative destruction is an essential element of a capitalist system. As long as our societies continue to espouse versions of capitalism, it will, for better and worse, be part of our lives.
THE REVIEW DECEMBER 2022 THE REVIEW MARCH 2023
“
ILLUSTRATION: PADDY MILLS/SYNERGY
Page 1 |
Page 2 |
Page 3 |
Page 4 |
Page 5 |
Page 6 |
Page 7 |
Page 8 |
Page 9 |
Page 10 |
Page 11 |
Page 12 |
Page 13 |
Page 14 |
Page 15 |
Page 16 |
Page 17 |
Page 18 |
Page 19 |
Page 20 |
Page 21 |
Page 22 |
Page 23 |
Page 24 |
Page 25 |
Page 26 |
Page 27 |
Page 28 |
Page 29 |
Page 30 |
Page 31 |
Page 32 |
Page 33 |
Page 34 |
Page 35 |
Page 36 |
Page 37 |
Page 38 |
Page 39 |
Page 40 |
Page 41 |
Page 42 |
Page 43 |
Page 44 |
Page 45 |
Page 46 |
Page 47 |
Page 48 |
Page 49 |
Page 50 |
Page 51 |
Page 52 |
Page 53 |
Page 54 |
Page 55 |
Page 56 |
Page 57 |
Page 58 |
Page 59 |
Page 60 |
Page 61 |
Page 62 |
Page 63 |
Page 64 |
Page 65 |
Page 66 |
Page 67 |
Page 68 |
Page 69 |
Page 70 |
Page 71 |
Page 72
