The Future Is Unpredictable (And That's OK)
Ask a CIO #8
It was a real treat to learn from Brian O’Neil last week, and thanks to all the readers that reached out afterward – glad you enjoyed it as well!
I launched this newsletter two months ago with the goal of sharing institutional investor insights in an accessible setting. I wasn’t entirely sure there would be an audience, but it’s been awesome and rewarding to hear from readers that are finding this newsletter useful.
Now that we’ve been at this for a little while, I admittedly need to scale back. My actual day job is rather all consuming (you might have heard that starting a company can be a bit intense), and finding the time to dive into three topics a week is tough.
If it’s alright with all of you, I’m going to dial it back to one topic per week. Let’s give it a try and see how it goes!
How much does your forward-looking view on interest rates impact your investing strategy?
I’ve received a handful of questions like this one – inquiries around either inflation, or interest rates, or some particular macroeconomic variable.
On the one hand, these questions are highly current and relevant, so I totally understand where you’re coming from. On the other hand – and this might be an unsatisfying answer – I generally don’t put too much weight into forward-looking views on any one variable.
It might feel like the news and talking heads are constantly discussing interest rates and weighing in with predictions for future Fed decisions. It might feel important to have a viewpoint and try to be accurate in your prediction. For most long-term investors, I would suggest that it isn’t nearly as consequential as you might think.
Let me frame this another way. Let’s pretend we go back in time to January 2023, and we tell 10 equity investors: hey, the Fed will raise rates another 1% through July 2023 then hold steady, with no cuts as of July 2024.
After we give them this ostensibly important piece of future data, we ask them to predict the S&P performance from Jan 2023 to July 2024. How many of those investors would have predicted the S&P would finish 2023 up 26.3%1, followed by another 14.7% through July 2024 (up 44.8% in total)? My guess would be zero. And I’m fairly certain, given the chatter in January 2023, that the predictions wouldn’t have even come close.
Then you might say, well of course it would be hard to predict market outcomes with only one piece of data. And you would be right! And that’s kind of the point. There are always so many moving variables. Beyond that, market participants often process and interpret data in unexpected ways, resulting in market behavior that can seem (and actually be) irrational. No matter how obvious a story might be in hindsight, these narratives are always written ex post. So let’s try not to overestimate either our predictive abilities or even the value of our predictions for any one variable.2
Now I’m going to answer your question, specific to interest rate expectations, in a slightly different way. It might even seem that I’m about to contradict all I’ve written up to here.
I do care about interest rate expectations. But I care about them as a relative risk input.
For instance, base rates today are above 5%. It would stand to reason that corporate borrower balance sheets are more strained in a 5%+ base rate environment than when base rates are below 1%. At the same time, investment grade and high yield corporate spreads are trading really tight relative to Treasuries.3 I might not know when the Fed will start to lower rates or to what extent it will lower rates, but I doubt it’s going to be quick and sharp enough to provide a lot of near-term relief to balance sheets. So I’m not hugely enthusiastic about corporate bonds, especially high yield bonds. I don’t think the return compensates for the potential downside risk.
I go back to the same question I always ask: as an investor, am I being appropriately compensated for the risk that I’m taking?
Thanks for taking time to join me each week, and as always, please send your questions along to askacio@ivyinvest.co!
Until next week,
Wendy
S&P 500 returns per Bloomberg
Now if we go back to January 2022, and you knew that the Fed was about to embark on a significant rate hiking cycle, that would admittedly be a different story! Those hikes are retrospectively referred to as a rate shock for a reason.
The ICE BofA US Corporate Index Option-Adjusted Spread is below 100bps, and the ICE BofA US High Yield Index Option-Adjusted Spread is just above 300bps.