Rate tracking 'tricking' investors into financial loss

The world’s central banks are expected to be nearing the end of one of history’s most aggressive monetary policy tightening cycles.

The US Federal Reserve has actioned a cumulative 500bps in rate hikes in just over 12 months, while in Australia, the Reserve Bank has lifted the cash rate by 375bps since May 2022.

Aggressive tightening has sought to stop inflation in its tracks, which the latest economic indicators suggesting central banks have largely achieved their objectives.

The Fed is tipped to pause rates at its next Federal Open Market Committee (FOMC) meeting, while most Australian economists expect the RBA to, at most, lift rates one final time in the months ahead.

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But according to Robert Almeida, global investment strategist and portfolio manager at MFS Investment Management, predicting rate movements to time investment decisions is a waste of time.

“Finance and economics are considered soft sciences. They’re soft because unlike physical sciences, they lack immutable laws,” he said.

“…Economies and financial markets are comprised of people making decisions. Sometimes those decisions are rational, often times not.”

“The absence of rules and laws often leads to narrative fallacy and attribution error as people rely on observations and patterns to ascribe cause and effect, sometimes confusing correlation with coincidence.”

These habits, he added, often lead investors into making poor financial decisions — described by Mr Almeida as the “devil’s trick”.

“The current consensus is we’re near the peak. While whether policy is or isn’t near peak seems relevant, it’s not. It’s a distraction,” he continued.

“The market is akin to a demonic beast that works hard to trick investors into making mistakes. It distracts investors from what really matters.

“And it’s been successful for centuries in this regard, separating people from their savings.”

Almeida said any prospective tightening or easing of monetary policy this year would not change underlying economic conditions and company fundamentals — already altered by developments over the past 12 months, particularly in the United States.

“The jump in capital costs over the last year was the fastest in four decades. Given the bulk of the US economy is fixed rate, now we wait to learn the effects,” he said.

He noted 74 US companies with liabilities exceeding $50 million have filed for bankruptcy since the turn of the year.

“When annualised, [it’s] surpassed the COVID lockdown year of 2020 when US gross domestic product collapsed by nearly one-fifth,” Almeida said.

He attributed the surge in bankruptcy filings to high levels of company indebtedness as part of a “just-passed era of artificially suppressed capital costs”.

“Today, those costs are dramatically higher than before and will be a material drag on future profitability for many enterprises and we’ve already seen its negative effects in some companies that have reported this earnings cycle,” he noted.

Projections of monetary policy easing later this year, he continued, won’t be enough to stem the flow of bankruptcy filings.

According to Almeida, investors should pay closer attention to company cash flow.

“I think the market is set up for disappointment, at least for the stocks and bonds of companies who were able to inflate margins on the back of low rates and cheap labour, which I think will catalyse a multiyear revolution for actively managed portfolios as a more difficult future operating environment separates the winners from the losers,” he concluded.

Beware of re-investment risks

Cuts to interest rates later this year call for a steady hand, according to American Century’s co-chief investment officer for global fixed income, John Lovito.

Lovito said monetary policy easing would slash yields on short-term cash equivalents like Treasury bills, cash deposits

“The dynamic between historical short-term rates and recessions suggests that investors holding cash equivalents still have time to potentially manage reinvestment risk,” he said.

“This refers to the inability to reinvest cash flows at a rate comparable to your current rate of return.”

Re-investment risks, he said, can be mitigated by “moving out on the yield curve” and “finding longer-term debt instruments”.

This could lock in higher rates and add duration, supporting capital appreciation when rates decline.

“In a recession, it’s all about quality in fixed income and we believe higher-quality bonds with attractive yields — including US Treasuries and higher-credit-quality corporate and securitised bonds — may help investors weather tough times,” Lovito said.

He said investors should continue diversify, focus on risk management to hedge against economic uncertainty, and look for unique opportunities in a bearish market.

“It’s also important to remember that attractive investment opportunities often emerge during market unrest,” he added.