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Adriaan Pask | Higher interest rates expose market vulnerabilities and ultimately opportunities

Adriaan Pask | Higher interest rates expose market vulnerabilities and ultimately opportunities
16-05-23 / Adriaan Pask

Adriaan Pask | Higher interest rates expose market vulnerabilities and ultimately opportunities

The recent banking crisis in the US and Europe, the largest since the 2008 global financial crisis, was triggered by rising interest rates. Silicon Valley Bank, Credit Suisse in Europe and several other US banks failed in March this year, revealing vulnerabilities in their business models and risk management practices. This outcome was predictable given the historical tendency for higher rate cycles to expose structural weaknesses in businesses. This time it is no different, especially given the fact that the last time interest rates increased so rapidly in the US was during the late 1970s.

To understand the impact of rising interest rates, let's take the example of a million-dollar loan that needs to be repaid over 10 years. Before interest rates increased, the annual interest cost was $2,500 at a rate of 0.25%. But with the interest rate at 5%, the interest payment alone is $50,000, which is 20 times higher. This money was previously being spent in the economy by businesses and consumers, but now it's being pulled out, and this has a significant impact on economic activity.

The knock-on effect of loose economic conditions

Loose economic conditions can also lead to the development of habits that must be unlearned during periods of interest rate hikes, affecting both consumers and businesses. During loose monetary policy, getting a loan is easier because banks have less stringent requirements and people can afford to overextend themselves. However, when interest rates rise significantly, previously good clients may struggle to repay their debt, resulting in fewer new loans and business for banks. Banks also need to make provisions for tougher conditions and adjust their lending models to be more cautious. This ultimately leads to a reduction in loan volumes and new clients.

Politics and markets are inseparable

The 2008 banking crisis is still fresh in many people's minds, and now, just over a decade later, something similar has occurred. There is an interesting history behind this, and politics seems to be inseparable from market discussions these days. After the global financial crisis, new banking regulations were put in place that proved to be tough on the banks, and ensured they were better capitalised.

However, this limited the amount of business they could do as not everyone qualified for loans, and they had to hold more capital on their balance sheets. The regulation named the Dodd-Frank Act was passed under President Barack Obama, but when President Donald Trump took office, he aimed for looser monetary policies and less regulation. Trump exempted some smaller to medium-sized banks from stress-test requirements, which ultimately resulted in the bank failures that we are now seeing.

Experience in tough times has set South African banks in good stead

In contrast, South African banks have remained well-capitalised and have been preparing for tough conditions for a long time. The banks' excellent navigation through the COVID-19 pandemic is a testament to their resilience. The global financial crisis also highlighted inter-banking risks, which facilitated corruption. However, the South African banks are insulated from these risks due to fewer touchpoints with other tiers of banks. Therefore, our banks are not at significant risk in this regard. However, the challenges faced by the South African banks are more directly correlated with local economic conditions.

What about a recession?

This all serves as a backdrop or precursor to the discussion about the possibility of a global recession, with the US yield curve serving as a leading indicator. Inverted yield curves, where short-term rates exceed long-term rates, have historically signaled a recession. The current yield curve inversion in the US is the largest in 43 years, making a recession statistically likely. If a recession was to occur at this stage, there would be little room for monetary or fiscal stimulus to support economies.

Consequently, negative growth is expected in the US, though slowing inflation may occur due to reduced demand and pressure on prices. Nevertheless, consumer-driven factors, such as wages, may take time to adjust, while commodity-driven prices, including food, may remain stubbornly high. South Africa's food inflation figures support this view.

High interest rates historically correlated with US bankruptcies

Historically, there is a strong correlation between interest rates and bankruptcies in the US, and many businesses could be caught out by the higher interest-rate environment. The reality is that markets are already pricing in a soft recession, with commodities struggling due to the lack of growth. China may be the only country that can buck the trend.

Another element to consider is higher unemployment, which is expected in the US, and will put pressure on wages and support slowing inflation. However, this scenario is poor for business and consumer sentiment, leading to hampered spending and possibly bankruptcies.

During a global recession, investors tend to seek safe havens, causing assets such as gold and US treasuries to perform well, while emerging markets tend to suffer - A trend that has been observed over this past year.

Times of upheaval can present opportunities

Despite the difficulty of living through a recession, the cyclicality of the market means that recessions come and go, leading to cheaper asset prices and good entry levels. For example, because of the war in Ukraine, European assets were priced excessively low over the last 15 months, creating investment opportunities such as BMW.

In the current environment, investors should, with the help of a financial adviser, consider assets that are bound to get cheaper, such as South African financials, which are currently already cheap and well capitalised. Other potential opportunities are in commodities and emerging markets, which may get cheaper in the short-term but offer good entry points for investors in the long-term.

*Adriaan Pask is Chief Investment Officer at PSG Wealth.

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