Scars & Unhealthy Risk Avoidance of Skyrocketing Interest Rates

Risk Avoidance Interest-Rate

“The spectacular rise in interest rates during the 1970’s and early 1980’s pushed many long-term market rates on prime credits up to levels never before approached, much less reached, in modern history. A long view, provided by this history, shows that recent peak yields were far above the highest prime long-term rates reported in the United States since 1800, in England since 1700, or in Holland since 1600. In other words, since modern capital markets came into existence, there have never been such high long-term rates as we recently have had all over the world.”

-Introduction to History of Interest Rates by Sidney Homer and Richard Sylla

It is human nature to never want to relive traumatic events.  After all, who wants to relive experiences that have left deep, painful scars? But if prior traumatic events have a realistically low probability of re-occurring, why be paralyzed by them?  Avoiding potential trauma that is unlikely to return can mean lost opportunity, which in the long run can be even more painful than the potential trauma avoided.

A deep, indelible impact is felt by those who lived through spiraling inflation and skyrocketing interest rates in the 1970s and early 1980s. Those were perilous times that investors understandably do not want to relive. This worry led many to sidestep a 30+ year bull market in bonds or avoid taking more risk with their capital in the aftermath of the Great Recession, for fear that interest rates would go through the roof due to quantitative easing by the Fed and large federal deficits leading to the re-emergence of inflation.

Investors that lived through the perilous 70s and early 80s were always looking over their shoulder for inflation and higher interest rates.  Consequently, they were financially handicapped by their fears and missed a decades-long bull market.  Savvy investors who didn’t share the same trauma studied history and realized that the extremely high rate era was a once in a 200 to 400-year event. Financial panics in early U.S. history and the tulip crash and panic in Holland in the 1600s were entirely different events highly unlikely to recur in the modern era of regulated markets.  Too many investors let their indelible fear of variable rates cloud their judgment and they paid the price in lost opportunity.

At the time of this writing, our real estate investment and management firm currently has over $2 billion** of debt financing supporting our portfolio of luxury apartments in areas that attract knowledge workers.  History and experience have shown the benefits of having a large percentage of our debt in variable rate loans versus fixed-rate loans. We’ve reaped the rewards from significantly lower interest rates, higher cash flows, and more pre-payment flexibility, unlike people unwilling to expose themselves to interest rate risk. Fixed-rate financing has turned out to be expensive insurance.

What About the Risk of Rising Interest Rates?

Looking forward, I still believe that our emphasis on variable rate financing is the right strategy. I do not fear inflation or materially higher rates, even though the Fed has in 2016 moved off its zero percent interest rate policy.

Here’s why:

  • Demographics – Unlike the 1970s, we have a much slower growing labor force and an aging society in the U.S. Savings will grow and the demand for yield will stimulate investments in companies with new technology that boosts productivity.
  • Globalization – Competition from around the world reduces prices as technology enables developing countries to bring more products and services to market. This should serve to keep labor’s share of national output at historically lower levels. And robotics are just beginning to come into practical use with deflationary consequences.
  • Unions – Far less influential and powerful today than in the 1970s, unions should serve to keep wage growth in alignment with productivity and lower than they otherwise were in the unions’ heyday.
  • Financialization – The huge focus on shareholder value leads to borrowing to buy back stock and pay dividends versus being invested in wage-generating activities. The significantly higher debt burden in the economy since the 1970s makes it that much more vulnerable to higher rates leading to an economic contraction. .Every major country that has raised rates since 2008 had to lower them subsequently because the economic cost was too high.
  • Oil – The U.S. has shown that it can and will bring supply to the market if prices again become elevated, helping keep inflation at bay. Saudi Arabia is cognizant of this. This was not the case in the 1970s. The days of long gas lines are thankfully a thing of the past.
  • Innovation – Capitalism rewards those that can lower costs and prices, raise productivity, and enhance the consumer experience. There is plenty of private capital to back entrepreneurs and firms that successfully do this. Capital’s reach is global and technological innovation can allow for this on a dizzying scale, which creates a disinflationary bias.

I will leave you with another important passage from History of Interest Rates to give some more historical perspective:

“Around the turn of the last century [1800s], a famous Austrian economist, Eugen von Boohm Bawerk, declared that the cultural level of a nation is mirrored by its rate of interest: the higher a people’s intelligence and moral strength, the lower the rate of interest. He was speaking of free market rates of interest, not of controlled rates of interest. In his time, market rates of interest throughout the principal trading nations of the world were historically low: 2.50% to 3.50% for long-term prime credits. And inflation was not then the problem that it would become in this century.”

Given the political discourse in this country and the general consensus that the array of presidential candidates is not very impressive, it’s surprising that interest rates are as low as they are if they are truly reflective of the United States’ cultural level as expressed through the people’s intelligence and moral strength. On the other hand, maybe America is much better off than most people believe. I digress as these ponderings are best left to another blog post.

I will leave you with this challenge:

Think about the scars and wounds you have experienced and how they may be stopping you from taking risks that may benefit you for fear of being hurt in potentially similar ways in the future. And then ask yourself how likely is it that I will really have that negative experience again? As Mark Twain says, “History doesn’t repeat, it rhymes.”  What we fear because of how we have been hurt is usually something we need to worry less about now as the pain trigger is usually different the next go around, particularly in the world of investing.

The most difficult thing to compete within life is our imagination.Click To Tweet

Try not to let the scars from your past create more wounds in the future by avoiding that which should not be avoided. The most difficult thing to compete within life is our imagination. No one can ever meet the standards of perfection we dream about and, therefore, people and situations invariably disappoint us. And, on the other hand, our imaginations obsessively remind us that we are certain of getting hurt again and opening old wounds, thereby making it virtually impossible for us to entertain any opportunity that could pay great dividends that might result in us getting hurt in similar ways. Fantasy trumps logic. Did I just use a derivative of Trump when talking about how fantasy trumps logic? I digress again. Does fantasy Trump logic?

Over to You:

Are you up for the challenge? 

**NOTE: This blog was originally published on March 7, 2016, the advice is just as relevant today as it was in 2016. All facts and figures presented are accurate as of that date and may have subsequently changed. A complete list of all CWS recommendations and current holdings is available upon request from our Investor Relations team. Please remember that past performance may not be indicative of future results.

One comment on “Scars & Unhealthy Risk Avoidance of Skyrocketing Interest Rates
  1. Doug W says:

    Great article … for investing and for life.

    Have a great week : >

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