Frank Thoughts: The Impact of Interest Rates
Frank Boland
June 15, 2020

When interest rates start to move higher, it will be considered a negative for the economy and the stock market. This reality started in in the middle of the last century.  General Motors was the largest corporation in the world, but rising interest rates proved very difficult to overcome. That contrasts sharply with the cash Microsoft, Apple, Facebook and Google generate today… and how little they need it.  It’s the difference between an industrial and a knowledge economy. The former was driven by the cost of money. The latter by the cost of knowledge which is driven by stock options.

As Fed funds rose from 1% in 1955 to 20% in 1982, industrial stocks went sideways for – at one point - seventeen consecutive years. Yet for active investment management, it was a golden period. Small and mid-cap growth stocks were phenomenal. Active management firms, such as Fidelity Investments and T. Row Price, had tremendous performance. One individual portfolio manager, Joe Mc Nay, established a record of 23.5% per year for twenty-five consecutive years! How was that possible?

It was a period of secular RISING INTEREST RATES (1955-1982) which creates stock market DISPERSION (stocks moving individually).  FALLING INTEREST RATES – such as 1982 to the present – do the opposite.  It creates high CORRELATION (stocks moving together as a group).  Moreover, it has been exacerbated by ETFs which have grown from 0 in 1993 to $4.5 trillion so far this year. That means close to half of trading volume is always 100% correlated. Are the underlying businesses? No!

My hypothesis for this dispersion/correlation phenomenon is that it is affected by the overall level of corporate profitability. As interest rates rise, a business must be profitable to survive. In the 1960s, investment banks wouldn’t consider bringing a company pubic if it wasn’t profitable. Today it is the opposite. Revenue growth is what matters. “Build it and they will come” is the common business model.  But that has worked just once for Amazon which is barely profitable after twenty-three years.        

With the development of the internet followed by financial and health crises, there has been deflationary pressure on interest rates for the past twenty-five years. Fed funds declined from 6% to 0.00%. In an economy where the “engine” is knowledge and discretionary spending the fuel, it shouldn’t be surprising the first “gas station,”, made its founder the richest man in the world. Since the business model, seemingly, worked for Amazon, it has been copied endlessly.

This has created dominant profitless companies such as Uber, WeWork, and Airbnb. The underlying premise behind them is the same. Build it without concern for profitability – assuming you have a large venture capital firm - until you are the business. But when a company runs into the law of big numbers, its investors will lose. In the ideal investment model, net income grows faster than revenue.

Interest rates are now the lowest in history; it is only a question of when – not whether – they move higher. As Milton Friedman once put it, “Inflation is always and everywhere a monetary phenomenon …” Simply put, it is too much money chasing too few goods. Consider that the last bear market in interest rates was caused by war, social programs and worker demands. Today the government is printing trillions of dollars to fund a war on Covid-19 and supplemental benefits to 40 million unemployed workers. To paraphrase Mark Twain, “History may not repeat, but it often rhymes.”   

-Francis Patrick Boland

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