Navigating equity volatility and higher rates
The US is raising interest rates to combat inflation at a time when conflict in Europe is roiling equity markets and threatening to tip the global economy into recession. Volatility is always challenging, but using existing holdings to generate liquidity can help investors diversify and manage risk.
The US Federal Reserve’s first interest rate increase in over three years has done little to calm the world’s equity markets. The March 16 decision to lift US policy rates by 0.25% had been intended to head off rising inflation. But since Russia invaded Ukraine on February 24, investors have been concerned that higher rates could help tip the world’s biggest economy into recession as the impacts of the war become clearer.
The US last raised interest rates in December 2018, before cutting the policy setting to zero in the face of the Covid-19 pandemic in early 2020. Since then, markets have been betting on the timing of the first increase, with a watchful eye on economic indicators – and especially prices.
Once US inflation hit a 40-year high, with the consumer price index rising by 7.5% year on year in January, the timing of the Fed’s first rate rise became a foregone conclusion. A further 0.5% increase followed in early May, and there are calls to take the policy rate up to 2.5% by the end of 2022.
The worry for equity markets, however, is that inflation is now forcing the Fed to increase rates at precisely the wrong time.
Russia’s invasion of Ukraine triggered an unprecedented array of international sanctions that have sent global commodity prices soaring, adding more pressure to already high inflation. Oil prices hit US$139.13 on March 7, the highest since 2008. This adds to the case for higher interest rates to cool price rises, but – on the other hand – the shock to the global energy system could also have a profound effect on economic growth.
Spiking oil prices have been devastating for economies in the past, most notably after the 1973 Yom Kippur War and the 1979 Iranian revolution – both of which were followed by severe US recessions.
Economist Paul Krugman has argued that the real hits to growth half a century ago came not from oil prices but from the policy response, warning that the Fed should not allow itself to be “bullied” into raising rates as dramatically as it did in the 1970s.
It is too soon to predict the direction the Fed will take in the remainder of 2022, and much will depend on the progress of the war in Ukraine. History suggests, though, that a rising interest rate environment will introduce more volatility to public equity markets.
Growth stocks have already been hit hard as investors factor in a higher risk premium on future cashflows. As of May 16, the US Nasdaq index had lost 25% of its value since the beginning of the year.
Some corners of the technology sector have fared even worse. Chinese stocks in the US have collapsed, as fears of further US sanctions on China and renewed Covid restrictions compound an already bleak outlook for growth. Digital assets have also been in turmoil, with prices of major cryptocurrencies tumbling by 30% or more in the first half of May.
Shelter from the storm
Managing this kind of volatility is a challenge for any investor, and especially concerning for shareholders whose wealth is concentrated in a single equity position.
With careful structuring, however, equity financing can help investors diversify their exposure without giving up on the long-term potential of the underlying stock.
Equity-backed lending allows investors to raise flexible funding for any purpose, such as investing in assets that are likely to outperform in a rising interest rate environment. After a strong run for growth stocks, for example, shareholders may consider monetizing part of their growth portfolio in order to invest in high-quality value stocks, which typically do well when rates rise.
Long-term shareholders can use equity financing to borrow money at a low rate of interest, as the shares are used as collateral to reduce the risks to the lender. Equity financing also allows investors to retain the potential for long-term appreciation in the underlying stock, as well as dividends.
EquitiesFirst is ready to work with accredited investors, professional investors, and otherwise qualified investors with experience of securities financing to discuss ways to mitigate the risks ahead for the equity markets as interest rates ratchet higher.
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