By Naomi Rovnick
LONDON (Reuters) – Fears that interest rates in major economies will remain relatively high are creeping back and threaten to deliver a painful wake-up call for financial markets, major investors warn.
With traders focused on expected summer interest rate cuts, global stocks remain at record highs and demand for bonds issued by the riskiest companies is high.
But asset managers and economists now expect only minimal monetary easing, especially from a US Federal Reserve that faces unexpectedly persistent inflation.
Big investors are not rushing to change their long-term investments, but in a sign of things to come, stock market volatility is near a six-month peak as traders debate how high the U.S. interest rate threshold at which financial assets are valued will remain.
Global stocks will suffer “a valuation loss from higher interest rates,” said Ann Katrin-Petersen, senior investment strategist at the BlackRock Investment Institute, the research arm of the world’s largest asset manager.
Amundi, Europe’s largest asset manager, said in a note Monday that U.S. stocks will lag globally over the next decade. It expects the shares and debt of companies in developing countries such as fast-growing India and mineral-rich Chile and Indonesia to outperform.
“Everyone is so focused on when rates are going to drop,” said Shamik Dhar, chief economist at BNY Mellon. “The much bigger question is what is the average level we can expect interest rates to revolve around.”
Traders, who have become accustomed to low interest rates flattering asset prices since 2009, are ready for “an adjustment in expectations, psychology and beliefs,” Dhar added.
NEW REGIME
The International Monetary Fund said Tuesday that the fed funds rate could fall more slowly than markets now expect.
BlackRock’s Petersen predicts that US interest rates will be close to 4% over the next five years and around 2% for the eurozone. “We have entered a new macro market regime and one of the cornerstones of that regime is structurally higher interest rates,” she said.
World stocks are up about 4% this year, hitting record highs in March. And an index of global junk bonds issued by indebted companies is at about the highest since 2021, buoyed by hopes that the Fed will cut interest rates from a 23-year high of 5.25% to 5%, boosting global credit and investment conditions remain buoyant.
But the point of reassessment is the discount rate that investors plug into corporate valuation models, which track long-term expectations for U.S. interest rates. An increase in this measure of one percentage point reduces the present value of companies’ future profits by 10%, accounting firm EY estimates.
Stock prices, especially in the US, are too high, investors say.
Wall Street’s S&P 500 index, which influences stocks worldwide, is priced 32% above fair value based on long-term interest rate forecasts, says Vanguard, the world’s second-largest money manager.
“If you do the global returns exercise, the 10-year exercise, mathematically speaking, future returns will be lower than what we’ve ever had,” says John O’ Toole, head of multi-asset solutions at Amundi.
The interest rate on ten-year government bonds, which is around 4.5%, already predicts a higher discount rate.
Risky investments are holding up in part because the cost of capital that investors plug into companies’ valuation models reflects previously agreed-upon cheap lending rates, says Qian Wang, senior economist at Vanguard.
With US interest rates expected to fall around 3.5% and a wave of corporate refinancings on the horizon in 2026, investors will be disappointed, she added.
HOW TO HANDLING THE SHIFT
An aging population, a shrinking workforce and Western economies moving production away from China are expected to keep inflation and interest rates high.
The escalating conflict in the Middle East has pushed oil prices near $90 as persistent climate shocks threaten to keep commodity prices high.
Markets are pricing in fewer than two Fed rate cuts this year. The European Central Bank’s first cut is priced for June, but traders have lowered their bets on how far it could go.
BlackRock’s Petersen said the group was neutral on equities, favored inflation-linked debt and viewed long-term government bonds as vulnerable to volatile inflation.
Tom Lemaigre, who manages 7.7 billion pounds ($9.58 billion) of European equities at Janus Henderson, said he could add to positions in banks that are doing well on high interest rates.
He has also become more positive about European industrial exporters benefiting from a strong dollar and US expansion in domestic manufacturing.
The shift to high long-term interest rates becoming entrenched in investor thinking is yet to come, Lemaigre said.
Still, the closely watched VIX measure of U.S. stock volatility has risen to around 19 after languishing at ultra-calm levels for months, while the comparable bond index is rising as unrest grows.
“If markets go from thinking there will be two (Fed) cuts to one and then (predicting) a rate hike, it will be very difficult for equity markets to survive that,” said Richard Dias, strategist at PGM Global in Montréal. .
(Reporting by Naomi Rovnick; Editing by Dhara Ranasinghe and Mark Heinrich)
