Four key challenges facing broker dealers during times of high inflation and how to overcome them – London Business News | Londonlovesbusiness.com

The pressures of inflation have been exceptional for institutional investors in recent years. With the widespread repercussions of high inflation set to stay with us for the foreseeable future, firms must face up to the challenges they must overcome to secure sustainable growth.

With news that the April 2024 Consumer Price Index (CPI) report saw inflation rise by a softer-than-expected 0.3% month-over-month and 3.4% year-over-year in the US, there’s renewed hope that the peak 9.1% inflation of 2022 is long in the rearview mirror.

However, the road to the 2% inflation target set out by the Federal Reserve remains an elusive goal for now, and while the skies are certainly clearing, institutions will have to contend with clouded conditions for a little while longer.

For Wall Street, the generative AI boom of 2023 helped markets overcome the deep losses experienced over the year prior, but with expectations for a Q1 2024 interest rate cut dissipating quickly due to persistent inflation rates, there’s growing anxiety that higher-for-longer interest may have long outstayed its welcome.

The impact of inflation on broker-dealers in particular is complex and can be difficult to overcome. With this in mind, let’s take a deeper look at the four biggest challenges facing these institutions and how they can combat them during the battle to control inflation:

1. Higher cost of borrowing

High inflation invariably leads to a more hawkish monetary policy from central banks. In turn, this means interest rate hikes and a higher cost of borrowing across the sector.

The impact of higher borrowing rates is a complex one for broker-dealers. On the one hand, the increased cost of borrowing means that broker-dealers can effectively earn more money on the cash they hold for clients, opening the door to an income stream that hadn’t been possible in the historically low-interest period of the 2010s.

However, high borrowing costs can also wreak havoc on financial markets. Companies that rely on debt to finance their operations can see their expenses ramped up upon every interest rate hike, and the difficulties in predicting rate hikes and cuts with any certainty means that markets can be prone to more volatility.

Additionally, higher interest rates mean that the required rate of return by investors is increased upon every Fed rate hike, making it more challenging for broker-dealers to identify investment opportunities on Wall Street.

In overcoming this, it’s important for institutions to adapt their strategies to place more value on companies that demonstrate higher free cash flow and have historically shown that their business models are durable during times of high inflation.

2. Increased rate of return for investors

High inflation forces markets to adapt quickly to changing investor mindsets. Broadly speaking, a hawkish monetary policy and higher interest rates can set a considerably higher bar for stock market returns.

With the availability of fixed-rate government bonds that can cling closely to interest rates, these yields can operate as a benchmark in which broker-dealers have to work harder to entice clients back into stocks and shares, creating a dilemma that can see clients looking elsewhere to balance their risk and opportunity.

For broker-dealers, this requires a more focused approach between risk and opportunity that can help to leverage stronger rates of return for clients while keeping in line with the appeals of bond markets during high-interest periods.

Fortunately, the tech stock rebound from 2022 lows thanks to the generative AI boom has kept global markets higher despite higher-for-longer interest, and using this as the foundation for strategies to rival alternative markets can help to continue ensuring healthy profitability during times of uncertainty.

3. Reduced customer demand

The rising cost of living owing to historically high inflation rates poses a long-term problem for broker-dealers and their investment strategies.

Although inflation is calming, the imbalance it’s caused between the cost of goods and services and wages means that stocks and shares will continue to face complex problems throughout business fundamentals in the US and beyond.

If consumers are unable to continue making their usual purchases at companies, their dwindling fundamentals will trigger alarm bells on Wall Street.

With volatility set to linger long into the future as a result of this, Allianz has suggested maintaining a diversified portfolio across different asset classes and locations. This can help institutions to take advantage of price fluctuations throughout different global markets.

Creating a more internationally focused portfolio is a strong advantage for broker-dealers, too. The post-pandemic recovery and struggle against inflation has been uneven, and this has seen different economies experience varied levels of outperformance and volatility alike.

Equipped with the right suite of resources, it’s possible to utilize synthetic prime offerings to tap into global equity, FX, metals, indexes, and commodity markets across a vast range of locations.

4. Reduced ability to invest in growth

The combination of high inflation and interest has a damaging effect on stocks because it creates widespread uncertainty in areas that would otherwise be capable of experiencing relative prosperity.

For growth stocks, the impact of high interest rates can be particularly damaging. Falling consumer spending power means that the profit and growth margins of companies can be heavily impacted, resulting in a tailspin of falling investor confidence and their perception of a stock as an unnecessary risk.

Due to the speculative nature of growth stocks, suffering a loss of investor confidence can be a major adverse impact of inflation. Losing key fundamentals in this way can prove fatal for small-cap growth stocks, and broker-dealers will need to be wary of this whiplash effect should inflation rates continue to linger longer than expected.

Dividend stocks can also suffer during times of inflation. For broker-dealers, it’s essential that growth stocks are well-researched and acknowledged as long-term investments. In the wake of the generative AI boom, many investors are drawn to faster gains, but adding growth stocks at a time of higher volatility should be recognized as an opportunity that could mature over the mid-to-long term.

Discovering new opportunities

Periods of high inflation can bring opportunities and risks for broker-dealers, but one of the most effective ways to overcome the volatility and uncertainty of financial markets during this time is to look further afield and embrace international markets at scale.

Emerging technologies can help institutions become closer than ever to the wider world, and this can help to ensure that they continue to meet the expectations of clients and maximize their profitability during the advantageous periods offered by historically high interest rates.

Regardless of the wider economic environment, financial services have become an increasingly competitive landscape. In using changing market conditions, it’s possible to out-innovate rivals and secure a better quality of service for clients long into the future.

Bio: Dmytro is an experienced finance, crypto, and investing writer based in London. Founder of Solvid, Pridicto and Coinprompter. His work has been published in U.S.News, Nasdaq, InvestorPlace, Kiplinger, Entrepreneur, InvestmentWeek, Finextra, Financial Express and The Diplomat. He recently completed an ebook for Make Use Of on “Introduction to Cryptocurrencies”. Dmytro is also a retail investor with open positions in NuBank, Duolingo, Disney, Verizon, HSBC and more.