Easy Money: A Historical Perspective

The term "easy money", often thrown around in financial circles, refers to a period when borrowing money is advantageous, interest rates are low and capital flows freely. It is an environment in which central banks keep interest rates low in order to stimulate economic growth and support economic recovery in difficult times.

This environment has persisted for more than a decade and has influenced the behaviour of investors, businesses and governments. Starting during the 2008-2009 financial crisis and until the end of 2021, real interest rates were below zero more than 80% of the time.

The reasons behind this were somewhat clear. The recovery after 2008 was slow at best, and quantitative easing - a programme of buying securities by central banks to give confidence to troubled financial markets - was used to kick-start the economy.

This was coupled with continued interest rate cuts, which stimulated the economy. The abundance of cash again encouraged risk-taking and investment. The ability to secure cheap financing allowed companies to invest in their operations and again stimulate future growth through capital expenditure and investment in research and development.

What Has Changed?

The end of easy money is not abrupt but rather the result of several interconnected factors. These changes are crucial to understanding the complexity of the current financial landscape.

Central Bank Policies

Central banks, such as the Federal Reserve Bank in the United States and the European Central Bank, have historically kept interest rates low in order to stimulate economic growth in difficult times.

However, these rates were kept low for a prolonged period after the 2008 financial crisis, leading to excessive borrowing and risk-taking in some areas, while encouraging investment in new areas across the economy. The US Fed's balance sheet has more than doubled since November 2019, the month the pandemic was announced to the world.

Inflationary Pressures

The resurgence of inflation is one of the hallmarks of the end of easy money. As economies reopened post-pandemic, there was a surge in demand for goods and services, coupled with rising commodity prices, fueling inflationary pressures.

The sheer scale of this can be seen by the changes in money supply as measured by the M2 aggregate globally. Just in the US, the M2 aggregate rose by 40% since the beginning of the COVID-19 pandemic and has stayed near those peaks ever since, while UK and the Eurozone experienced changes around the 20% mark. All that in under 4 years.

In the second quarter of 2020, central banks deployed quantitative easing to stimulate markets that were already in free fall. As part of this measure, the Fed expanded its balance sheet enormously.

Furthermore, government stimulus programs aid at preventing poverty were distributed across the American population totaling over 814 billion dollars. All this money found its way either into the economy or into the financial markets leading to higher inflation as many people became flush with cash.

The ability to sustain oneself without the need to work or work as much as one used to also had a negative effect on labor markets as many low-wage workers were either unable or unwilling to return back to work. You can likely remember the articles about McDonalds offering bonuses for people who were willing to show up for an interview regardless of whether they would end up working for the company. This once again led to a surge in labor costs, setting the stage for future inflation.

To make things worse geopolitical uncertainty and uneasy markets began to fuel further inflation. Geopolitical tensions, trade disputes, and the ongoing global health crisis have introduced unpredictability into financial markets. We could see this manifested by the semiconductor shortages that affected most of the advanced economies, while bottlenecks in energy supplies combined with the war in Ukraine have troubled most of Europe. 

How did easy money affect financial markets?

The era of easy money significantly impacted financial markets, with equity, bond and real estate markets being at the forefront of these changes.

Bond Markets

The easy money era, characterized by prolonged periods of low interest rates and quantitative easing programs, has had a profound impact on bond markets. In this environment, yields on government and corporate bonds have plummeted to historic lows, as central banks sought to stimulate economic growth and encourage borrowing.

The initial effect of falling interest rates has been a rise in bond prices. But the long-term extremely loose monetary policy has translated into a challenging environment in which traditional fixed-income investments have delivered poor returns. Many investors were forced to seek higher-yielding assets, thereby taking on more risk, or to diversify into other asset classes.

In addition, easy money has inflated bond prices due to pent-up demand for safe, yield-generating assets.

Equity Markets

Equity markets have experienced a tumultuous journey during the easy money era. Initially, the low interest rates and abundant liquidity boosted stock prices, as investors sought higher returns than those offered by bonds and other traditional assets.

Companies with access to cheap credit found it easier to finance growth initiatives and buy back their own shares, further bolstering stock prices. Eventually, easy money also boosted firms' own profitability, thanks to strong household consumption and low costs of foreign funds, which led to record corporate profit margins.

However, the easy money era has also heightened market volatility. Investors have become increasingly sensitive to shifts in central bank policy and economic indicators, leading to rapid market swings in response to even minor changes in interest rates or economic outlooks. This heightened volatility has made it more challenging for investors to navigate equity markets with confidence.

However, many have used the opportunities presented by easy money wisely- Companies like Coca-Cola and Procter & Gamble and many more, have benefited from low-cost financing to invest in expansion, research, and innovation.

Real Estate Markets

In the realm of real estate, the easy money era has been marked by skyrocketing property prices in many regions. Low interest rates have made mortgages more affordable, driving up demand for homes and investment properties. This surge in demand, combined with limited housing supply in some areas, has led to rapid price appreciation and, in some cases, housing bubbles.

Investors have also flocked to real estate as an alternative investment to low-yield bonds and volatile equities, further driving up property prices. Real estate investment trusts (REITs) have offered investors exposure to real estate markets without the hassle of property ownership, adding to the popularity of this asset class.

However, concerns about affordability and the sustainability of real estate price growth have emerged as well. Easy money policies have contributed to housing market imbalances, with some markets becoming unaffordable for many potential buyers. As central banks eventually normalize interest rates, the real estate sector may face challenges, including the risk of price corrections and potential stress in mortgage markets.

What does this mean for financial markets in the long run?

Bond Markets 

Yield Reversal: As interest rates rise, bond yields are likely to increase, which could lead to bond price declines. Investors holding low-yield bonds may face capital losses. However, these will be temporary as long as they are patient and hold the bonds to maturity, at which time they will be paid face value.

Nevertheless, everything can be good for something. This shift has meant that bonds have started to offer interesting yields that we have not heard of for the last 15 years, and they are "in play" again after many years.

Even the 1-year U.S. government bond, the safest security on the market, currently offers a yield of over 5.4% p.a. (as of Oct. 5, 2023), the highest level in nearly 23 years. This is indeed an attractive offer in excess of inflation.

As the previous chart of the yield on the 1-year US government bond shows, short-term cash deposits are already delivering some appreciation again after 15 years. Finax has responded to this development this year. The most conservative product, the Smart Deposit, accurately allows you to take advantage of current interest rates in the eurozone without fluctuations in value.

To reduce credit risk, focus on high-quality bonds, especially in a potentially turbulent market environment, as issuers of riskier, so-called high-yield bonds may have difficulty refinancing and repaying in a higher interest rate environment.

Credit Quality: Notice how we mentioned risky bonds in the previous paragraphs. Consider the example of bonds in the Chinese construction sector, a market fueled by low rates and high borrowing mixed with high rates of fraud and lacking disclosures has led to billions being destroyed in bonds of companies such as Evergrande and Country Garden.

Equity Markets 

In a higher interest rate environment, firms will face greater challenges. One of them will be the issue of financing. Most firms will no longer have access to cheap capital in the form of loans and bonds. Small businesses will therefore face greater problems than larger established firms. However, regardless of size and capitalization, access to cheap capital will be severely limited.

That is why firms that are able to use debt for sound investments such as research and development of new or existing products can grow in this environment. At the same time, higher interest rates should have a lower impact on well-capitalized firms, or those that are not already facing problems with their own liabilities.

The problem may arise for firms that were already unable to repay their debts during the era of easy money and relied on the possibility of refinancing at low interest rates. Firms with poor capital structures will thus be forced to rethink and adjust their approach to financing.

At the same time, we are likely to see fewer acquisitions and new public listings, as the high cost of financing them will be a significant barrier for firms. Even now, we are already seeing a drop in volume in the acquisitions market, which is down more than $1 trillion year-over-year. The valuations of many companies that were planning to go public in the near term have acquired lower valuations, such as payment provider Stripe, whose value has fallen by almost half since the pandemic. Going forward, therefore, we can expect fewer unicorns and a tougher environment for startups relying on cheap capital.

Despite higher interest rates, however, equities should remain the most lucrative asset for investors. Company managements can adjust to higher interest rates, which are ultimately nothing exceptional. Corporate profitability will grow over the long term and equities remain the asset with the greatest potential appreciation.

Real Estate Markets

The end of the easy money era is likely to have a significant impact on real estate markets. As central banks begin to normalize interest rates and reduce monetary stimulus, borrowing costs for homebuyers and real estate investors will rise.

Demand for real estate is slowing and will potentially lead to a cooling of heated property markets, which have seen rapid price growth in the recent past. Housing affordability may improve for some, but those who have relied heavily on cheap credit face problems.

Real estate market will likely feel the ripples of higher interest rates globally. In March, Blackstone, one of the biggest private equity managers defaulted on its bond backed by Nordic real estate mortgages.

Swedish real estate was one of the hottest in Europe before the interest rate hike. Since the policy change by the central banks, they have fallen by more than 20% from their highs. The same can be said for most property markets in all developed countries, with a few bright exceptions such as Singapore, where prices are still rising despite measures aimed at cooling the property market.

How to adapt to this change

1. Diversify your portfolio

Spread your investments across different asset classes such as equities, bonds, real estate, and alternative investments. Diversification can help mitigate risk. As Warren Buffet famously said, "It's only when the tide goes out that you learn who has been swimming naked." In our case, an outflow of cheap money can expose a number of companies that tend to ride waves of abundant liquidity. At this time, as mentioned above, conservative asset classes make sense again. Bonds, which have seen record declines over the past three years, will once again shine as their yields have reached levels of 3 to 6%, which are already values worth considering. New to the market are money market instruments with maturities of up to one year, which are yielding similar yields and which also benefit Smart Deposit.

Even in this environment, therefore, we recommend not deviating from investment strategies and staying invested in the market. Building wealth, preparing for retirement, saving for children's futures or securing housing are long-term goals covering horizons over decades. In this case, equities remain the most promising asset with the greatest return potential.

From a diversification perspective, Finax portfolios offer an ideal solution. Indeed, the passive approach to the entire market involves a wide range of assets and thousands of instruments in each class, whether it is equities, bonds, commodities, or real estate.

2. Explore your risk tolerance 

Assess your risk tolerance and adjust your portfolio accordingly. Consider reallocating assets to match your risk tolerance and investment objectives.

Dissatisfaction with an investment or failure to manage an investment is most often the result of misplaced expectations, lack of knowledge, or misalignment (taking on more risk than an investor can handle). So don't chase returns. This approach can backfire.

Returns go hand in hand with risk, they are directly proportional to it. If you can't handle fluctuations in the value of your investment, say goodbye to more appreciation. Risk tolerance is only increased by knowledge and experience of investing, e.g. by experiencing and weathering market downturns.

Finax can help you in this respect too. Our online advisor's algorithm will select the right portfolio for you. All that matters is to think about the questions in the investment questionnaire, evaluate your plans and risk tolerance correctly and answer them truthfully.

3. Long-term perspective

Remember that investing is a long haul. Declines in asset values are part and parcel of investing. This is not exceptional. They are literally the price you pay for long-term above-average returns. They are a translation of risk, which is a prerequisite for achieving attractive returns. It is a sufficient horizon, i.e. giving the investment enough time to show all the benefits and compounding effects, that is the fundamental condition for a successful investment. Avoid impulsive decisions based on short-term market fluctuations, which can mean a double loss: the recognition of the current loss and the loss of profit on the return of the investment.

While the end of easy money may seem like a turning point, it is not the end of the world, and financial markets have been in this situation many times. Strong economies can also cope with normalised monetary policy, which is, after all, a more natural and welcome phenomenon than negative interest rates.

While it may bring increased volatility and challenges, it also offers opportunities for investors who adapt wisely. By understanding the changing environment, diversifying your investments and maintaining a long-term perspective, you can navigate this new era of financial markets with confidence and resilience.

The key is not to deviate from a long-term investment strategy that takes into account different scenarios in its outlook. It is long-term passive investing that offers a happy medium, covering different asset classes, diversifying widely and taking advantage of whatever trend the economic situation brings to the financial markets.