volatility

Low interest rates are still good for markets


The information in this article is market commentary only and reflects Lincoln's views and beliefs at the time of preparation, which are subject to change without notice. To obtain up-to-date information, please contact us.

Volatility has well and truly returned to global equity markets, with many investors awakened from their slumber after a prolonged period of stable returns. Many were quick to define the correction as a symptom of rising inflation concerns in the US on the back of increased infrastructure spending, which will deepen the deficit, lead to further increases in interest rates and push up long-term bond yields. The diagnosis? Market volatility is here to stay.

Too often, market observers attribute specific reasons to broad-based market sell-offs. If only investing were that simple. The only answer to the question about why the market fell that is 100 per cent correct is that more investors were willing to sell stocks than buy them. If that hadn’t been the case, the sharemarket would have gone up.

It’s often a worthwhile exercise to deconstruct the reasons for a market decline and look at how those same factors have contributed to returns over the long term. Take the argument that fear of rising interest rates was behind last week’s volatility.

It is true that uncontrolled inflation, which results in central banks moving interest rates higher to calm the economy, is generally not good for the market. However, are all interest rises a bad thing, particularly when rising interest rates often occur when the economy is doing well? Low interest rates will often signal a struggling economy.

We analysed the behaviour of United States markets relative to interest rate levels over time to determine if now may be the dawn of an imminent deep correction in the US. Should it occur, we would be caught in its net.

The attached graph shows the correlation between weekly sharemarket returns in the US and interest rates, as denoted by 10-year US treasury rates, since 1960. A positive correlation (above 0) is a positive return, whereas negative (less than 0) is not so good.

There are two distinct clusters: one in the top left corner (positive results), the other in the bottom right (negative results). The positive results tend to occur when interest rates are below 5 per cent, and it is only once interest rates creep above 5 per cent that the probability of negative performance becomes more likely.

The comfort of a story

As with all things, there are outliers where the norm was not followed. However, to say that the next correction will be due to “higher interest rates” would be more a case of pot luck rather than historical evidence, given that there is still some way to go before we get to the 5 per cent historical tipping point, even if the Federal Reserve lifts rates four times this year.

We believe the recent market gyrations are a sign of a market that is behaving normally. The reality is that volatility is a symptom of the market being forward-looking as it attempts to predict the future. Add the fact that shares are priced every second of the trading day, and it is easy to see why latching onto a broad idea, or concept, can provide comfort and commentary for some when investors are selling more than they’re buying.

We constantly remind investors that they should be focused on the things they can control and that is the quality of the stocks in their portfolio and alignment with their investment objective. Just let the market do its thing. Be proactive when a decision needs to be made, particularly when the fundamentals take a turn for the worse.

We often joke that the market has correctly predicted seven of the last three recessions. If it’s any consolation, analysts aren’t very good at predicting the future either. A sobering reality for those of us who make their living analysing companies and the market.

 

Published Tuesday, 19 February 2018
www.afr.com. | Financial Review

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