Do High Interest Rates Indicate That We Are “Back To Normal”?


John Zaller, CIO, was joined by Chris Grisanti, Chief Equity Strategist, to provide their latest thoughts on the current market environment.

Long Term Picture: The Great Financial Crisis of 2008

Asked often when things will “get back to normal,” Chris reminds people to pull the lens back and look at the long term. In 2008, the financial markets imploded, leading to a scary time for everyone. The Federal Reserve lowered interest rates to zero for the first time and embarked on countless programs to stabilize the economy. In 2009, then-CIO at PIMCO, Mohammed El-Erian coined the phrase, the new normal, to describe the era of extremely low interest rates, low inflation, sluggish employment, and low GDP growth. Other phrases during that time included pushing on a string or the less negative, priming the pump, to describe the Federal Reserve’s effort to lower rates in order to get the economy back on its feet.

Impact of the 2020 Pandemic

The pandemic in 2020 gave the Fed and the politicians the political cover to do the ultimate “pump priming,” and they dumped over $5 trillion into the economy. Like starting an old automobile engine that fails the first few times but then starts with a bang, that finally ignited growth – and inflation – and brought us full circle back to the pre-financial crisis era.

In other words, back to the “old normal.”

Federal Reserve Funds Over the Past 52 Years

The easiest demonstration of how we are back to normal is a chart of the Fed Funds rate for the last 52 years. When you review that chart, the last 15 years are the “weird part,” with virtually zero interest rates.

While interest rates are currently considered high, compared to historical data, they are about average. And at those levels, they could be considered a feature of a healthy, growing economy. No one likes to pay higher mortgage rates, but if you live in a growing economy with more opportunities to increase income, the higher rates are an acceptable trade off.

Chris notes, “My strong hope—and I think it will turn out to be true—is that we have finally reached what I would call escape velocity, and the economy will not need to return to constant support from the Federal Reserve in order to support housing or stock prices.”

But as with everything, there is a catch.

Five Negatives about High Interest Rates

  1. Equity investors now have alternatives. TINA   – or there is no alternative –  is dead.  (Sorry TINA) and equities are not the only game in town.  Bonds have come back from the dead.
  2. Companies are facing a much tougher capital structure environment. Debt is more expensive and floating rate debt or maturing debt that needs to be rolled is a real issue.  Balance sheet quality will matter again (it has mostly been ignored for 15 years).
  3. No earnings/no cash flow companies will face a much harder time coming public or raising additional capital. Virtually no IPOs right now.
  4. The discount rate for growth is much higher, lowering the present value of growth (read technology and communications) companies. This lowers the price of formerly market leading tech stocks.  (Think about Tesla’s 2027 potential earnings—even if they come true, what are they worth today?)
  5. Psychologically, investors start focusing on what could go wrong, not the unlimited potential of a growth company. The glass is now half-empty.

All these points may seem alarming, but are simply part of a normal economy. Company balance sheets SHOULD matter—it is only in the last 15 abnormal years, when money was basically free, that they haven’t. And it isn’t a bad thing that not every company can go public—some aren’t prepared for that.

A “Normal” Economy: Learning from History

What is most important for investors to remember is that there were plenty of years with higher rates and that market did just fine—or even wonderfully. The best example is 1995 to 1999. During those years, the Fed Funds rate averaged 5.4%, about half a percent higher than now. And in those 5 years, the S&P 500 Index rose 250%, more than tripling. While not a prediction, the point is to say that higher rates don’t always mean a bad equity market. Higher rates are the result of a stronger economy, which generally leads to higher corporate earnings, which drives stock prices.

Simply said, historically, higher rates do not always lead to a lower market.

Information updated as of 02.23.2023.

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