[Gentle Explanation] 'Higher for Longer' Interest Rates from Jackson Hole: The Basics of Investing Without Being Swayed by News of 'Dying Assets' and 'Reviving Assets'
Hello!
Every year at the end of summer, there is an event that financial professionals around the world watch with bated breath: the Jackson Hole Economic Symposium, hosted by the Federal Reserve Bank of Kansas City.
At this year’s conference, the Chair of the Federal Reserve (Fed) made important remarks regarding future interest rate policy, which resulted in the market becoming strongly conscious of a ‘higher for longer’ interest rate environment.
At the start of the week, an acquaintance who just started investing came to me with a very anxious voice and asked for advice: ‘I read in an online news article that because high interest rates will persist, the stocks I’ve been buying will become dying assets! From now on, such-and-such will revive! It scared me. Is my installment investment okay?’
‘Dying assets’…
If someone used such terrifying words to describe your precious money, anyone would panic, right?
However, let me tell you clearly.
‘Please, rest assured. The extreme words like “dying” or “reviving” in news headlines are largely just sensationalism. In economic terms, it is simply that a changing of the guard is occurring between “assets facing headwinds” and “assets receiving tailwinds.”
Today, based on official Fed reports and top academic papers in financial economics, I would like to explain ‘what happens when high interest rates continue’, as well as “gentle investment techniques practiced by professionals that won’t be defeated by the winds of the market.”
While drinking a warm cup of coffee, let’s learn together how to ride the waves of the global economy.
1. The True Meaning of ‘Higher for Longer’ Interest Rates
First, let’s calmly decipher the intention behind why the Fed is trying to keep interest rates high.
When you read through official data such as the ‘Monetary Policy Report’ that the Fed periodically submits to Congress, their message is very clear.
It means, ‘To completely cool down the heat of inflation, we need to continue with “high interest rates” for a while longer. And because the current US economy and employment are extremely resilient, there is the capacity to endure these strong high interest rates for a long period.’
In other words, the continuation of high interest rates is not because ‘the economy will collapse,’ but is a reflection of the positive confidence that ‘because the economy is strong, we can defeat inflation without compromise.’
It is by no means pessimistic news that the world is ending.
2. The True Identity of Assets Facing ‘Headwinds’ as Revealed by Academic Papers
So, why is there such a fuss that ‘certain stocks will become useless if interest rates are high’?
A highly authoritative and recent paper titled ‘Duration-Driven Returns’ (Gormsen & Lazarea, 2020) by Professor Gormsen and colleagues at the University of Chicago, published in the world’s top academic journal for financial economics, ‘The Journal of Finance,’ provides a clear answer to this.
What this paper scientifically proved is the fact that stocks, just like bonds, have a concept of ‘duration’ (the period until invested money is recovered) and are strongly influenced by fluctuations in interest rates.
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[Assets Facing Headwinds (Stocks with Long Duration)] These are growth stocks, such as AI and cutting-edge technology companies, that promise, ‘We may have little profit now, but we will generate massive profits in 10 or 20 years!’ When interest rates rise, investors think, ‘I don’t have to wait that far into the future; I can get high interest from safe bank deposits or government bonds.’ As a result, the value of profits in the distant future (present value) is mathematically discounted, making stock prices more prone to falling.
They are by no means ‘going bankrupt.’ A calm perspective is that, as a result of being re-measured by the ruler of high interest rates, ‘prices that were a bit too high are simply being adjusted to their appropriate levels.’
3. The True Nature of Assets That ‘Revive’ by Catching a ‘Tailwind’
On the other hand, there are assets that are re-evaluated as the prolonged high interest rates become a ‘strong tailwind.’
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[Assets Catching a Tailwind (Stocks with Short Duration/Financial Stocks)] These are ‘value stocks’—companies that are currently generating massive profits in cash and paying high dividends, rather than 10 years from now—and ‘financial stocks like banks,’ where profit margins expand as interest rates rise.
As proven in a recent top paper by Professor Drechsler and colleagues at New York University (Drechsler, Savov, & Schnabl, 2021), financial institutions such as megabanks with a solid deposit base generate massive profits in a rising interest rate environment by raising lending rates while keeping deposit rates suppressed.
Also, cash-rich companies with plenty of cash on hand can invest that cash at high interest rates, so their performance is boosted in an era of high interest rates.
These ‘plain but currently solid-earning companies,’ which have been hidden in the shadow of glamorous technology stocks until now, begin to shine as protagonists in the era of high interest rates.
4. Summary: The Magic of ‘Index Investing’ That Doesn’t Fear the News
Let’s summarize this analysis.
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The True Meaning of Jackson Hole: As indicated by the official FRB report, the prolonged high interest rates are an expression of ‘confidence in completely suppressing inflation, backed by a resilient economy.’
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Assets Facing Headwinds: As academic papers (Gormsen & Lazarea, 2020) prove, when interest rates rise, the valuation of ‘growth stocks’ that expect profits in the distant future is easily adjusted mathematically.
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Assets Catching a Tailwind: As academic papers (Drechsler et al., 2021) show, value stocks that are currently earning cash and financial stocks like banks where margins expand are strongly re-evaluated.
‘Then I have to hurry and sell the tech stocks I own and buy bank stocks!’ For those who have become impatient, I will offer some advice to lighten your heart.
If you are investing monthly in index funds like ‘All Country (All World Equity)’ or ‘S&P 500’ through the new NISA or similar accounts,you already own ‘everything’—both the assets facing headwinds and the assets catching a tailwind.
The wonderful thing about index funds is that they have an ‘automatic balancing function’ at work, where financial stocks and value stocks provide solid support while technology stocks are being adjusted.
Even if the leading roles change with the times, you have no blind spots because you hold both from the very beginning.
Being frightened by extreme online rhetoric about “dying assets!” and stopping your hard-earned accumulation is the most wasteful action you can take.
Think to yourself, “Ah, the market is just in the middle of passing the baton to the next leading role,” and while sipping a warm cup of tea, please continue your asset formation with peace of mind and confidence!
References
・Board of Governors of the Federal Reserve System. “Monetary Policy Report”.
・Gormsen, N. J., & Lazarea, S. (2020). “Duration-Driven Returns”. The Journal of Finance, 75(3), 1339-1378.
・Drechsler, I., Savov, A., & Schnabl, P. (2021). “Banking on Deposits: Maturity Transformation without Interest Rate Risk”. The Journal of Finance, 76(3), 1091-1143.
＊Note: The content of this article is only a portion of the subject matter and does not definitively conclude all aspects of the topic.