Analysis – Painful wake-up call on high interest rates threatens global markets | WTAQ News Talk | 97.5FM · 1360AM

By Naomi Rovnick

LONDON (Reuters) – Fears that interest rates will remain relatively high in major economies are creeping back and threaten to trigger a painful wake-up call for financial markets, major investors warn.

With traders fully focused on expected summer interest rate cuts, global stock prices remain near record highs and demand for debt from the riskiest companies is stable.

But asset managers and economists currently expect only minimal monetary easing, particularly from a Federal Reserve facing unexpectedly persistent inflation.

Large investors are not rushing to change their long-term holdings, but in a sign of things to come, stock market volatility is near a six-month high as traders debate how high the U.S. interest rate hurdle will remain against which financial assets will be held be rated.

Global equities will “suffer a decline in valuations due to higher and longer-term interest rates,” said Ann Katrin-Petersen, senior investment strategist at BlackRock Investment Institute, the research arm of the world's largest asset manager.

Amundi, Europe's largest asset manager, said in a note on Monday that U.S. stocks will underperform the world over the next decade. The equity and debt of companies in developing countries such as high-growth India and mineral-rich Chile and Indonesia are expected to outperform.

“Everyone is so focused on when interest rate cuts are coming,” said Shamik Dhar, chief economist at BNY Mellon. “The much bigger question is what is the average level at which we can then expect interest rates to fluctuate.”

Traders who have become accustomed to low interest rates flattering asset prices since 2009 are facing an “adjustment in expectations, psychology and beliefs,” Dhar added.

NEW REGIME

The International Monetary Fund said Tuesday that the Fed's key interest rate could fall more slowly than markets currently expect.

BlackRock's Petersen forecasts U.S. interest rates of just under 4% and the Eurozone around 2% over the next five years. “We have entered a new macro market regime and one of the cornerstones of that regime is structurally higher interest rates,” she said.

World stocks have risen about 4% this year, hitting record highs in March. And an index of global junk bonds issued by indebted companies is at about their highest level since 2021, supported by hopes that the Fed will cut interest rates to 5% from a 23-year high of 5.25% will – keeping global borrowing and investment conditions remaining exuberant.

However, the discount rate that investors incorporate into company valuation models and that tracks long-term U.S. interest rate expectations needs to be reassessed. An increase in this measure by one percentage point reduces the present value of companies' future profits by 10%, estimates the accounting firm EY.

Share prices, especially in the US, are too high, investors said.

The price of Wall Street's S&P 500 index, which influences stocks worldwide, is 32% above fair value based on long-term interest rate forecasts, according to Vanguard, the world's second-largest asset manager.

“If you do the global return analysis, the 10-year analysis, future returns will be mathematically lower than what we have had so far,” said John O'Toole, head of multi-asset solutions at Amundi.

The yield on ten-year government bonds of around 4.5% already suggests a higher discount rate.

Risky assets are holding up in part because the cost of capital that investors factor into company valuation models reflects pre-agreed favorable borrowing rates, said Qian Wang, senior economist at Vanguard.

With U.S. interest rates expected to settle around 3.5% and a wave of corporate refinancings looming in 2026, she added, “investors will be disappointed.”

CHANGE THE LAYER

An aging population, a shrinking workforce and Western economies shifting manufacturing away from China are expected to keep inflation and interest rates high.

The escalating Middle East conflict has sent oil prices soaring to nearly $90 as ongoing climate shocks threaten to keep commodity prices high.

Markets are pricing in fewer than two Fed rate cuts this year. The European Central Bank's first interest rate cut is priced in for June, but traders have reduced their bets on how far it can go.

BlackRock's Petersen said the group is neutral on stocks, favors inflation-linked debt and views long-term government bonds as vulnerable to volatile inflation.

Tom Lemaigre, who manages 7.7 billion pounds ($9.58 billion) of European stocks at Janus Henderson, said he may add to positions in banks that are benefiting from high interest rates.

He was also more positive about European industrial exporters, which are benefiting from a strong dollar and expanding domestic manufacturing in the United States.

The transition to high long-term interest rates that is becoming entrenched in traders' minds is “still coming,” Lemaigre added.

Still, the closely watched VIX gauge of U.S. stock volatility has risen to a reading of around 19 after months of sleeping at extremely calm levels, while the comparable bond index is rising on increasing unrest.

“If markets go from thinking there will be two (Fed) cuts to one and then (forecasting) a rate hike (forecast), it's going to be really hard for stock markets to survive that,” Richard Dias said , strategist at PGM Global in Montreal .

(Reporting by Naomi Rovnick; Editing by Dhara Ranasinghe and Mark Heinrich)