Policymakers believe the economy is on a strong footing, but the pace of rate increases going forward remains uncertain, and the effects on asset management could be significant. The Federal Open Market Committee is set to meet on Dec. 19, and an interest rate increase of 25-basis-points appears to be 75 percent likely, according to Bloomberg analysts. Meanwhile, there is just a 3 percent chance of another increase during the Jan. 31 meeting. Federal Reserve Chairman Jerome Powell cited slowing demand abroad, fading fiscal stimulus and the lagging effect of the Federal Reserve’s several rate increases on the economy since 2015 as possible headwinds.
Trade tariffs bring substantial uncertainty to the markets as well, as companies reinvent their supply chains to preserve profit margins. Rising interest rates call into question how investors will deploy capital and could create a sell-off for asset managers who prefer safer assets. Fixed income and credit products are likely to grow in popularity; the three-month Treasury yield has outperformed the S&P 500 dividend yield since the second quarter of this year. In the first nine months of 2018, real assets, real estate and debt are additional asset categories that have attracted more capital from investors than they did during the same period in 2017.
Higher interest rates will pinch private equity returns, but a significant de-escalation in mergers and acquisitions (M&A) activity is not imminent. Private equity (PE) firms often fund the takeover of companies using debt. Over the last several years, these firms have benefited from historically low interest rates and have generated high returns, beating the S&P 500 Index by a compound annual rate of return of 5 percent. Returns are likely to decline and PE-owned companies will focus instead on maintaining steady cash flow to service their increased borrowing costs. Firms looking for acquisitions will benefit from declines in pricing, while the opposite will be true for sellers. Approximately $1.1 trillion of commitments remain available for deployment, and a 25 basis point or greater increase in rates is unlikely to decelerate M&A volume.
