Investors build up portfolios as interest rates rise globally

More than 4.7 million new accounts were opened on the Moscow Exchange in 2020, about as many as during all previous years combined. Even in the United States, where investment has long enjoyed mass cult-like followings, there’s an unprecedented excitement now. Last year, 15% of all investors were newbies, which is also a record for America. What prompts investors to open new brokerage accounts?

There are several reasons, including lowest interest rates on bank deposits in history, lockdowns and digitalization of investment. Yes, it has become much easier to invest. All you need is to install an investment app and register a trader account while still sitting on your couch. However, it is not enough for tens of millions of people to instantly decide that they should start trading on the stock market. One of the key factors included reducing interest rates to almost zero (in Russia, to the historic low of 4.25%) and a liquidity injection by central banks. People came to banks and were offered – in Russia – 3% deposits, which is still better than in Europe or America where you would have deposited at 0%. There was literally no choice but to put one’s money in stocks where it would make at lest 3–7% in dividends. 

As soon as it became clear that the Federal Reserve System and other central banks can issue an unlimited amount of money, investors immediately realized that they have iron support. Selling assets when there is a buyer with pockets full of trillions of dollars would be a losing strategy.

As a result, major stock indices, including Russian, are renewing their historical highs day after day. Investors and illicit dealers almost religiously believe that the Federal Reserve System will not abandon markets and will save everybody by printing a couple more trillions. There is even a popular meme on the market called Buy the Dip which means that, in case of any market correction, it is advisable to buy out stocks because there is so much liquidity on the market that money is not as important as real assets. For example, every month, the Federal Reserve Systems buys $120 bln worth of bonds. Why not do the same along with such a big buyer? It would be stupid to play against it.

But everybody understands: this situation will not continue forever. The inflation rate in the United States showed an unprecedented growth of 5% in May 2021. Initially, it caused some alarm among investors but the Federal Reserve System has always been able to calm down the crowd. Jerome Powell knows how to put up a brave front. He claimed that the inflation growth is temporary and the rate will go down as soon as next year.

In an effort to avoid heating up the market, the Federal Reserve System buys later bond issues to control the yield curve. What does it mean? It means that, if later US bond issues (also called “treasury notes”) start falling in price, it results in higher yields. Rising yields make the market nervous and stocks go on sale. Bonds are bought out to prevent market tensions.

Still, the Federal Reserve is not the Almighty and it can’t control everything. There are certain risks right now that can bring the stock market down. One is the uncontrolled rise in inflation. Then, there is a new wave of COVID-19 caused by the Delta strain. Finally, economic indicators have deteriorated after a turbulent recovery.

The interest rate hike deserves a closer look. Interest rates can increase for a number of reasons, one of which is upturn in inflation. The amount of money injections into the system is excessive. These injections have partly replaced the money lost from the economy due to the pandemic. However, in the wake of price hikes in the commodity market and shortages in certain sectors (for example, the oil market and the semi-conductor market), prices in the United States have gone up significantly.

The Russian Central Bank also started increasing the key interest rate rapidly, and it will be rising even faster after the recently published statistics on the inflation growth of 6.5%, the highest inflation since 2016. It can be expected that in H2, some of the funds will start moving from stock market to bank deposits, which may cause another correction of the Moscow Exchange index.

Still, the interest rates in Russia have no effect on the global capital market. The dollar being the world’s primary transaction currency, much more depends on the Federal Reserve System. So Jerome Powell can’t just begin to increase interest rates like the Central Bank does. It would likely lead to a sharp fall in prices both of shares and bonds all over the world. And we must remember that many Americans depend on pension funds which invested trillions of dollars on financial markets. For the Federal Reserve System, to cause a market crash is to leave pensioners without pensions. Thus, the world’s main central bank has a very complicated task: to increase the interest rates as smoothly as possible to avoid causing a global recession.

Most major investors do not expect that the Federal Reserve System would raise the interest rates beyond 2.5% even in the long term; otherwise it could cause a global financial crisis. During the years of an ultra-soft monetary policy, the state and private corporations have cumulated tens of trillions worth of debt. The increase of the interest rates even by 1% will sharply reduce the companies’ income and will affect the already deficit-ridden budget. On other words, increasing the interest rates is a dangerous and disadvantageous maneuver.

However, it will have to be made someday. The black swan of inflation might heave in sight very soon. Something like that already happened in the US in the late 1970s; the only weapon against it was the sharp and steep increase in interest rates.

If your portfolio mostly contains stocks, you should be careful. The latest comments by the Federal Reserve System show that the buyback program will soon be reduced, which means the liquidity will lower. There is no need to sell off the entire portfolio: it will take at least one or two years to increase the interest rates. The markets can grow even more during this time.

However, it is recommended to refrain from major purchases of stocks and long bonds. It’s best to increase the share of cash or, speaking of the ruble, put the money on a deposit account at a floating interest rate. Looking into foreign currency could be another option. I believe that the second half of 2020 will be a very volatile period.

By Dmitry Cheryomushkin, Managing Partner, Xelius Group 

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