Why low interest rates of the past are fueling present-day uncertainty

History shows that when the U.S. Federal Reserve makes it inexpensive to borrow money, investors are more likely to make poor financial decisions. While it can take years to manifest, the consequences of suppressing the cost of capital usually can result in financial or economic turbulence.

After more than a decade of historically low interest rates, it's my view

that this scenario is presently playing out in the markets and economy. In the past year, some financial stresses have emerged: cryptocurrencies have been upended, special purpose acquisition companies have floundered and several U.S. banks have failed.

To help you better understand current market and economic conditions, here are three unintended consequences of the prolonged low-interest rate environment from 2008 to 2022:

Consequence 1: Bank failures may lead to slower lending.

The current U.S. banking troubles are different from the 2008 global financial crisis. In 2008, banks were insolvent due to years of making bad consumer loans. Today, they are solvent but illiquid due to deposit outflows.

Years of subdued savings rates and anemic demand for consumer loans pushed banks into investing deposits into bonds. But savers shifted out of deposits into higher yielding money market funds and T-bills. At the same time, rising interest rates pressured the value of bond investments, resulting in a mismatch in assets (the value of the bonds) and liabilities (deposits) and the stresses seen in recent weeks.

While more banks may fail, it's my view that this isn't a systemic banking crisis. However, the fallout could fuel a climate where deposit-funded banks are less willing to lend, possibly accelerating the pathway to a recession.

Consequence 2: Corporate profits may fall.

Over the past 10 years, corporate debt issuance rose because interest rates remained low. The Fed hoped that capital would be funded into projects — plants, property and equipment — to create economic growth.

That didn't happen. Instead, companies bought back stock, raised dividends and made acquisitions. Corporate profit margins (the portion of a company's revenues left after subtracting costs) reached all-time highs amid the weakest economic growth cycle in over a century.

In any case, we believe high profit levels are over. Companies financed debt at low rates, but now have to refinance at higher rates. At the same time, they're dealing with rising labor costs, higher inflation and slowing demand. Moreover, COVID exposed the weakness of "just in time" supply chains and globalization. Onshoring — bringing supply chains back to the U.S. — will take a large amount of capital spending which puts further pressure on profits.

We believe the quality of today's profits is very poor and is consistent with the bad decisions spurred by interest rate suppression.

Consequence 3: Market volatility is likely to be a more common occurrence.

In the decades leading up to 2022, there was less market volatility. That environment, in my view, is behind us. A lower profit margin environment is very different from the past two decades and financial markets will have to adjust. As unknown consequences emerge, we believe markets will experience volatility.

Finding a silver lining.

Volatility creates more opportunity for dispersion — a greater range of returns for investments — and active management. This new environment may set the stage for a multiyear transition in leadership from passive funds to active funds and create significant opportunities for value generation.

As such, active managers can potentially help investors find new opportunities by identifying companies with strong competitive positions and pricing power that may provide some protection for earnings in an uncertain environment. The ability of active management to add value above a benchmark may be key to meeting long-term portfolio goals.

Your financial adviser can help you weather uncertainty and will provide personalized investing recommendations that align with your financial goals, time horizon and risk tolerance. If you have any questions or concerns, don't hesitate to reach out to them today.