It's all about Interest Rates

Despite improving economic conditions, markets fell heavily at the end of January 2019. Stock markets seem to react negatively to good news...so what's going on?

After sifting through the tsunami of economic commentary and company reports the conclusion is that Equity and Bond markets are reacting to the threat of increasing interest rates.

When economies grow, central banks react to rising inflation by increasing interest rates. ​ Inflation has been subdued since the financial crisis, in spite of the significant stimulus packages injected into many of the world's major economies by their central banks. The sustained pick-up in global growth has only just started to stir any meaningful inflationary forces.et in touch

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Key indicators of inflation at work are:

• Energy prices - bottoming out in February 2016, the price of a barrel of Nymex Crude Oil has risen more than 120% to $65. Almost every single sector of the global economy is directly or indirectly, reliant on oil.

• Wage inflation - US wage inflation appears to be finally on the rise, with average wages rising 2.9% in January, the highest rate of increase since June 2009.

• Synchronised global growth - The global economy continues to strengthen, with growth synchronised across all major geographic areas - the first time this has happened since the 2008 financial crisis. Strengthening economic activity equates to rising demand, which in turn will likely drive upward pressure on pricing.

• Weak dollar - A weaker dollar, if sustained over a period of time, will result in higher US inflation, as the US is a net importer of goods.

What are the implications for investors? Equity market performance is normally relatively unaffected during the early stage of central bank interest rate hikes as these are seen as a sign of a central bank's confidence in the strengthening economy. ​ This improving economic growth outlook is theoretically positive for equity markets, as it indicates potentially higher levels of corporate profitability in the future. ​ It also benefits confidence, both at the corporate and consumer levels, as individuals and businesses are more likely to invest when the economic outlook is improving. ​ However … Markets have steadily risen on the back of speculation and momentum. Some Share prices have benefited from the possibility of growth, fuelled by low interest rates rather than the intrinsic growth in companies profitability, through increased sales. ​ Conversely as interest rates rise, corporate profit margins will reduce and expose business models that are only sustainable when finance is cheap. ​ Investors looking for security over their capital have struggled to find returns attractive from banks and have been forced to purchase Shares and Bonds in order to drive a higher rate of return; another significant factor in the constant upward march of these asset prices. ​ If interest rates increase then investors will be able to receive a greater return from cash and therefore demand a higher premium from shares and bonds. ​ When higher premiums are demanded via dividends from shares or yields on bonds, one of the effects is that purchase prices are driven lower which makes the premium greater in relation to the ‘new’, lower purchase price. ​ All of which points to a return of volatility in markets albeit against a positive outlook further down the road. ​ Get in touch with us if you think these factors may affect you and your savings.