Great Expectations – Recent Stock Market Turmoil

My comments are intended to provide a sense of perspective on recent stock market events. I believe that they key factor driving markets at the moment is expectations of interest rate movements.

The simple rule is that there is a hierarchy of risk and returns:

A) If banks are paying low interest of say 0.5% then:-
B) A Government Bond is a bit riskier because it can fluctuate in value, so you will want 1% interest as your reward for the additional risk.
C) For a Corporate Bond (a bit riskier still) you will want maybe 2-3% interest
D) To buy a share you would want the possibility of even more income as dividends and/or the chance of some capital growth.

So if interest rates rise, you will need even higher levels of income from the riskier investments to compensate for the potential down side.

The interest payable on Government Bonds and Corporate bonds tends not to change – it is more of a ‘fixed sum’ that is payable. So if you are receiving a fixed income payment of £2 (2%) on your Bond which is worth £100 you will need the value of the Bond to drop to £66 to increase the effective interest to 3%. A similar effect can be seen on shares too.

What Triggered the Recent Fall in Stock Markets?

Reports of wage increases in the US indicated that inflation might rise faster than expected – which in turn could trigger interest rate rises in the US to keep inflation under control, much faster than originally expected. The stock markets reacted in anticipation of interest rate rises.

The US Federal Reserve has been signalling future rises for some time, and outlining in very rational terms what circumstances would need to occur to push rates up. Until very recently, the message and the circumstances have all been very consistent and steady. The jump in earnings data was stronger than expected and pushed circumstances beyond the steady rhetoric from the US Federal Reserve, so the reaction was stronger.

Are Global Stock Markets Overvalued?

One measure of that helps answer this question is the Price Earnings ratio (PE) – a measure of how much income is generated by each business compared to its share price. The higher the PE the more likely it is to be overvalued. In the US the PE is very high, but in other markets it quite low – such as Russia and Brazil. Global Markets fell in response to the US fall, perhaps as more of an emotional reaction. Some markets have undoubtedly been at very high values.

Are Interest Rates Going to Rise Further?

The Central banks in each country or region decide this. It seems likely that rates will rise in the US, and that other developed markets could eventually rise in turn, such as the UK and the EU. But in other areas, interest rates are already much higher, such as in China, Brazil and Russia. In these areas rates may fall as a way to stimulate further growth.

What can you reasonably expect in the future?

The key factor driving markets is still likely to be interest rates, in my opinion. Countries that have higher interest rates can see a strengthening currency, and those that reduce rates can see the value of their currency slide. Coupled with that, bond markets and stock markets will continue to react to interest rate movements.

The combined effect of currency and investment market fluctuations mean we may see a period of volatility, especially where portfolios are more globally invested.

The Good News!

It is important to remember that this stock market movement was not instigated by an economic or financial crisis. There was no systemic collapse or bankruptcy, there was no conflict or natural disaster. Indeed, the global economy is still in good health.

Rising interest rates and inflation are signs of economic strength so overall this is good news.

And in the long run, well diversified investment portfolios are still a good way to hedge against the effects of inflation to protect your wealth.

As ever, the value of investments can fall as well as rise. Please don’t base any investment decisions on the basis of my comments here – always seek professional advice. Your capital is at risk.

Andrew Moore
Investment Director and Partner

Posted In : Investments, Market Commentary, Newsletters, Interest Rates