The impact of the current monetary policy regime

July 2024 by André Themudo

The current monetary policy regime: what impact could it have on the market?

In the wake of the pandemic, the world has undergone a major transformation and we have entered a new era. This event not only changed social norms, but also left a clear mark on the world economy. The pandemic acted as a catalyst for one of the fastest and most aggressive cycles of interest rate hikes in recent history, in response to the high inflation resulting from the difficulties in production chains and the reduction in the workforce. In the wake of the health crisis, governments around the world have adopted unprecedented stimulus measures in their economies in order to mitigate the financial consequences. This, in turn, fueled a significant rise in inflation rates, which led central banks to embark on a path of monetary tightening, reaching levels from prior to the 2009 financial crisis.  

New market regime

Given the uniqueness of this situation, we believe that we are in a new market regime, where the strategies and conclusions of the past do not apply to this new context. We are now witnessing greater dispersion both in the behavior and results of companies and in economic data, and it is increasingly difficult to estimate growth and inflation. However, this scenario of high interest rates has not hindered the growth of economies, which have managed to balance the reduction of inflation with the maintenance of growth. And this cycle of rate hikes was different from other times in the past, because both households and companies were in a very healthy state. On the balance sheets, debt levels were very low and households had high savings ratios compared to the historical average after the accumulation during the pandemic.

As a result, we haven't seen the same weakness in the microeconomic component as in the past, and the cycle of rising interest rates hasn't excessively affected the financial conditions of companies and households. However, the last few years have been very challenging for investors, who are trying to make an efficient asset allocation in an unprecedented context.

The need to be active

In this new regime, we believe that it is more important than ever to be active within the investment portfolio, reviewing our allocation periodically and analyzing the sources of risk. The same patterns of return and risk of the past do not apply to this new regime. In recent years, for example, we have seen how stocks and bonds have moved side by side in the same direction. This made it difficult for investors to find refuge in the midst of a change in monetary policy, where the biggest unknown was to what extent central banks would raise rates and when cuts would begin. 

This scenario of high interest rates put companies whose activity depends on long-term flows, such as the technology sector, and segments that are more sensitive to tougher financing conditions, such as small and medium-sized enterprises, in check during the period of hikes. The fact that risk-free assets are providing higher returns calls into question the expected return on shares, so investors demanded more from this asset class and are sensitive to valuations. 

Dynamism in asset allocation

In addition, bonds yields have risen in recent years, which, although it has negatively affected investors who have invested in the movement of bond prices, has brought current levels to levels not seen for decades. For example, high durations gave the portfolio unusual volatility, and we found the same levels of return in the short parts. This is why we are now advocating dynamism in asset allocation, recognizing that the rules of the past may no longer apply to this new regime. 

In short, we believe that we will be living with high rates for longer and that the economies will not return to the interest rate levels of the past in the short term. Inflation will continue to be persistent, albeit controlled, meaning central banks will keep rates in a restrictive position for longer.