ANALYSIS - Painfully High Interest Rates Wake Up Global Markets

By Naomi Rovnick, resonator

LONDON (Reuters) - Worries that interest rates in major economies will remain relatively high are rising, large investors warned, risking a painful wake-up call for financial markets.

With traders highly concerned about expectations of a summer rate cut, global equity markets remain near record highs and demand for debt issued by the riskiest companies is strong.

However, asset managers and economists now expect only a minimal easing of monetary policy, especially as the U.S. Federal Reserve faces an unexpectedly high level of persistent inflation.

Large investors were in no hurry to change their long-term holdings, but stock market volatility reached a six-month peak as traders debated how high the U.S. interest rate hurdle, which underpins the valuation of financial assets, would remain.

Ann Katrin-Petersen, senior investment strategist at the BlackRock Investment Institute, a research arm of BlackRock, the world's largest asset manager, said global stocks will be "dragged down by the fact that interest rates The higher and longer they are, the higher the valuations will be".

U.S. stocks will lag globally over the next decade, Amundi, Europe's largest asset manager, said in a report Monday. It expects stocks and debt in developing countries such as high-growth India, asset-rich Chile and Indonesia to outperform the broader market.

"Everyone is focused on when rates will be cut," says Shamik Dhar, a premier economist at Bank of New York Mellon." The bigger question is what we can expect the average level of the interest rate cycle to be at that time."

Dhar added that traders, who have become accustomed to low interest rates supporting asset prices since 2009, are in for "an adjustment in expectations, psychology and beliefs".

New Deal (Roosevelt's 1933 policy deal with the Great Depression)

The International Monetary Fund said Tuesday that the Fed funds rate may fall more slowly than the market currently expects.

BlackRock's Peterson predicts that over the next five years interest rates will be close to 4% in the US and about 2% in the Eurozone," she said. "We have entered a new macro-market system, and one of the cornerstones of that system is a combination of higher interest rates.

Global stock markets have risen about 4% this year, hitting record highs in March. Hopes that the Federal Reserve will lower interest rates to 5% from a 23-year high of 5.25% have supported an index of junk bonds issued by the world's indebted corporations that is close to its highest since 2021 - keeping global borrowing and investment strong.

What needs to be reassessed, however, is the discount rate used by investors in the company's valuation model, which follows long-term U.S. interest rate expectations. Ernst & Young, an accounting firm, estimates that the present value of the company's future earnings will decline by 10% for every percentage point this rate rises.

Investors say that stock prices, especially in the U.S., are too high.

Vanguard, the world's second-largest money manager, said the Wall Street S&P 500 Index, which influences global stock markets, is priced 32% above fair value based on long-term interest rate projections.

"Mathematically, where you do the global rate of return, the 10-year rate of return, the future rate of return [will be] lower than the rate of return that we've got," said John O'Toole, director of multi-asset solutions at Amundi.

The 10-year Treasury yield is around 4.5%, already signaling a higher discount rate.

Vanguard senior economist Qian (王倩) says risky assets have held up in part because the cost of capital that investors enter in company valuation models reflects previously agreed-upon low lending rates.

She added that U.S. interest rates are expected to stabilize around 3.51 TP3T, and that there will be a wave of corporate refinancings in 2026 that "will be disappointing to investors."

Transaction Changes

An aging population, a shrinking workforce, and a renewed shift of production from China to Western economies are expected to keep inflation and interest rates high.

An upgraded Middle East syncopation has pushed oil prices to near $90, and the ongoing climate shock threatens to keep commodity prices high.

The market expects the Fed to cut rates less than twice this year. The ECB's first rate cut is expected to take place in June, but traders have lowered their bets on the magnitude of the cut.

BlackRock's Peterson said the group was neutral on equities and favored inflation-linked bonds, saying that long-term government bonds were vulnerable to inflationary fluctuations.

Tom Lemaigre, who manages £7.7 billion ($9.58 billion) worth of European shares at Janus Henderson, said he may increase his position in banks, which have done well at high interest rates.

He is also more bullish on European industrial exporters that are benefiting from a stronger U.S. dollar and the U.S. expanding its domestic manufacturing sector.

Lemaigre added that long-term high interest rates will become the mindset of traders and that this change is "not here yet".

To be sure, as jitters mount, the closely watched U.S. stock volatility index, the VIX, has risen to about 19 after months of slumber, while comparable bond indexes are moving higher.

"If the market goes from thinking there are going to be two (Fed) rate cuts, to one, to a (predicted) rate hike, it's going to be very difficult for the stock market to weather that," said Richard Dias, a strategist at PGM Global in Montreal.

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