Now that February has passed; a month that saw tumultuous stock market volatility, especially in the US, it seems appropriate to take a slightly less fevered look at where we are now and where we may go from here.
The first thing to note is that the US market has recovered the bulk of its losses, with the year to date return on the US S&P 500 being a positive 2.7%.
As we have noted previously most US market sectors are showing strong earnings growth and projecting increased profits both from business activity and the bonus of the corporate tax cut.
Internationally companies are performing well with growth in Emerging Markets, Japan and Europe.
So, given this pretty much universal corporate economic good news, why are the major markets so skittish?
Surely these should be the optimal conditions to give strong returns as performance improves and, in all likelihood, will keep doing so for a while.
NowThings vs FutureThings
One of the more confounding drivers of market direction is the element of ‘Futurology’ involved.
This is to say that markets are always attempting to look into the future, trying to divine where things will be in say 18 to 24 months’ time, then applying this forward position back to stock values in the present.
This explains in part why markets can run ahead of things actually getting better if markets believe they will, and conversely lagging behind as now when the data is positive.
It’s all about rates
The Financial crisis of 08/09 is now a piece of economic history in many ways.
Banks are mended, house prices are well up, markets sit at all-time highs and memories have faded.
However, a major consequence of that crisis remains absolutely front and centre for markets and their future projections.
Interest rates were slashed to negative real costs (they were lower than the inflation rate) after the crisis and massive amounts of liquidity (cash) pumped into the system by Central Banks buying their own debt (treasuries, Bunds, Gilts etc).
This was all absolutely necessary and helped (many many books will debate by exactly how much) to stabilise a staggering world economy.
But today with economies and companies firing on many more cylinders, labour at near-fully utilised levels, with wages rising and inflation beginning to tick up, well, what happens next is their concern.
So, markets have begun to battle the opposing forces of rising profits on the one hand (good), and the future likelihood of rising interest rates on the other (evil).
Why are rising rates kryptonite?
The modern Western economic system has to a large extent been built on the availability and growing utilisation of credit.
In essence Governments, Companies and individuals have borrowed more and more to fund what they want to spend, long before they could have paid for it with their own money; in some cases they would never have been able to do so.
So, business activity and personal consumption has been turbo-charged by enabling what would have taken many years (if ever) to fund internally, is now available immediately because of external credit.
Many economists continually point out the perils of ever increasing debt and the financial crisis such as 2008, was a stark example of the nuclear threat posed by leverage/borrowing against a physical asset whose value is only so high as long as the ability to borrow more remains unfettered (in essence the financial version of the king’s new clothes).
But the reality is that we are now firmly on the ‘debt merry go round’ and as it spins ever faster there’s no realistic way to get off.
Consider therefore the effects over the last 25 years, of rates falling from an average of let’s say 8% to 2% (a reduction of 75% or put the other way an increase required to get back to the high of 300%).
What has this allowed to happen?
- Governments have been able to borrow much more because the overall servicing costs are much lower. So Sovereign debts have ballooned but repayment costs have not.
- Companies can borrow much more for the same reasons as Governments plus their existing debts have been refinanced at much lower rates which has reduced costs, thereby increasing profits.
- Individuals have hugely benefited from falling mortgage costs; far and away their biggest expense and house prices have boomed for exactly the same reason, much lower costs of borrowing.
- For financial assets the story is the same; bonds – values have soared as yields have fallen, commercial property – same as Bonds, and high dividend paying equities such as Utilities – same.
Invert, always invert
The physical world is predicated on the overarching law of balance and symmetry, that for every action there will at some future point be an equal and opposite reaction.
A prolonged singular action of something doing only one thing can come to seem to many that, in fact, that’s just how it is and always will be.
Considered over longer periods it’s clear that cycles can be long, but they will at some point end and the longer they have travelled in one direction, the longer they will then take to travel back or the distance may be quickly and violently traversed.
Particular concern should be registered when something can travel no further in one direction, the risk is then Asymmetric, in that what happens next can only be a change to the opposite direction (such as when interest rates go to zero).
So ‘inversion thinking’ is simply to ask the question:
“What happens when the direction reverses?”
If we therefore look at the above assets and invert the interest rate movements up instead of down:
1. Sovereign debt:
Values fall on the resale market.
New debt issuance becomes more expensive to service.
This causes greater deficits.
Requires more borrowing.
Weakens credit rating so interest rate increases.
Values fall more on resale market.
2. Company Debt
Bond yields rise.
Bond capital values fall on secondary market.
Debt servicing costs increase.
Share price reduces.
Companies reduce spending.
Cut back on costs including employment.
Lower profits means lower taxes paid, which increases Government balance of payment deficit which means they either borrow more or cut back on services including employment in public sector.
Mortgage costs increase.
Employment less secure.
Discretionary spending cut back.
House prices fall.
The above is the Faustian nightmare scenario of what rising interest rates can mean and there is no indication rates will rise violently or excessively, but it gives a flavour of why their upward direction is starting to haunt the market.
Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.