Investors often read that markets discount expectations about business results, the solvency of an issuer, or the supply and demand for commodities, for example. Everything is correct, but money quantity and cost matter in these expectations.
I always remind clients to pay special attention to the increase in the money supply and the change in interest rate policies, because these two elements have an exceptional impact on the market trend in terms of expansion of multiples, risk perception, and what is usually called “market sentiment,” which, in reality, usually almost perfectly reflects if the environment is one of monetary expansion and low rates, which usually lead to a bullish sentiment.
Market participants seem nervous these days because of a summer correction in August and early September. However, paying attention to monetary aggregates should indicate to us why the long-term bullish trend is unchanged.
The reference rates set by central banks affect the financial market in several ways:
Interest rates significantly alter the cost of capital, which discounts companies’ cash flows and affects share valuation. This effect is especially evident in private equity investments.
Reference interest rates also affect debt costs, increasing the financial burden of refinancing and leverage operations. That is why it is common for a sharp rise in rates to lead to a sharp fall in commodities, even when demand and supply are strong. The cost of financing long positions—also called bullish—or of refinancing “margin calls,” or of financing freight and demurrage, increases, and with it, commodities fall.
In addition, when rates are raised by the Federal Reserve, the dollar usually strengthens because the supply of the global reserve currency is reduced. This effect is also significant on financial markets because emerging markets may find it difficult to refinance debt in dollars, hoard dollars in their central bank, or attract investments, as investors prefer to buy U.S. debt at appropriate rates rather than take higher risk with debt from emerging countries. This effect, which I call the “dollar suction effect,” leads to the amount of dollars in the economy being reallocated toward low-risk assets and the United States, with the opposite effect occurring in periods of rate cuts.
Let us not forget that markets discount expectations. Therefore, the biggest changes in the trend occur when rate expectations are downward. Currently, market consensus expectations are signaling four rate cuts until December. Investors may find this exaggerated, but as the economy slows down, the trend in money supply growth and negative real rates could soon reappear.
In theory, central bank reference rates should reflect inflation expectations and be a tool for correcting the money supply during periods of excess inflation or deflation risk. However, since 2008, there have been cases in which central banks were wrong and maintained expansionary policies for a prolonged period, thereby generating excessive optimism in the financial markets, which subsequently led to a strong correction when central banks normalized their policy. These corrections have proven to be opportunities to buy equities for the long term, as the historical trend of money growth and central bank easing is unchanged.
When investing in fixed income, the key is to analyze real interest rates, i.e., those adjusted for inflation. Rate cuts can push these real rates into negative territory and generate distortions, such as an extraordinary appetite for risk or the accumulation of risk in toxic assets when the perception of risk becomes clouded.
In a free market, interest rates float freely, but it is true that central banks, by setting the reference interest rate and amount of money, have a huge impact on estimates. If the monetary authority reduces the reference rates, it is reasonable to discount the fact that commercial banks will apply this reduction to loans to families and companies. In fact, central banks tend to take measures on rates to encourage the creation of new credit in times of low growth or recession and raise rates to reduce the pace of credit growth—which is the amount of money in the system—in periods of expansion or high inflation.
Interest rates affect companies’ valuation, debt repayment ability, and, therefore, issuer solvency. They also have a significant impact on investors’ ability to assume risk.
Interest rates represent the cost of risk. A price below the real level of risk can generate a dangerous and mistaken perception of security, leading to bubbles or excess debt. On the other hand, setting interest rates too high can discourage investment and credit.
Falling rates also lead to higher leverage decisions in investments for market operators, as well as increased exposure to duration in fixed income (long-term debt).
In order to invest in a rate-cut environment, we must understand a few things: Rate cuts are the manifestation of a slowing economy. Therefore, reducing exposure to cyclical bets and adding to defensives helps. In a stock or bond, the quantity and cost of money are as important as the details of the profits, margins, cash, and debt.
Central banks do not set their monetary policy and interest rates based on capricious or random decisions. They understand that inflation is a fundamental monetary factor and that decisions regarding the quantity and cost of money hold significant importance in managing the market, ensuring sufficient liquidity, and generating credit for investment and families.
The central bank knows that the transmission mechanism of monetary policy is complex and that distortions can occur. But at the same time, we know that the history of money shows that the medium-term result is inflation in financial assets, i.e., bullish for stocks.
Central banks cannot make fiscal policy, which is why it is essential that they are independent of the states. If central banks were dependent on the states, inflation would not be controlled, because state imbalances would not be moderated. Remember, the state deficit artificially creates money; the only factor that triggers an inflationary process is the issuance of more currency than the demand for it. Therefore, it is better to avoid sovereign debt duration in a long-term portfolio.
The next wave of rate cuts may generate some volatility in markets, but investors must understand that the subsequent monetary expansion is inevitable, considering the increase in government debt in developed and emerging economies. Stocks may appear vulnerable during periods of temporary volatility, but they prove to be, along with gold and bitcoin, the best way to invest in an inevitable monetary expansion to offset the loss of currency purchasing power, understanding that short-term volatility may be ahead, but long-term asset inflation, rising stocks, and corporate bonds are also likely.
