The return of volatility has awoken those lulled to sleep by the gentle rocking of the second longest bull-market on record. The culprits are global interest rates, but why have the financial markets reacted in this way?
Volatility is a normal function of the financial markets. The recent record low levels were unusual and unsustainable.
There were many times we thought the markets would awake before now – Britain’s shock Brexit vote, Donald Trump’s victory in the battle for the White House, or even the threat of nuclear war.
How interest rates work
It’s the role of Central Banks to use monetary policy to keep inflation in line with a predetermined target – in the UK it’s 2%.
When Central banks want to stimulate the economy and encourage spending, they might lower interest rates to make borrowing cheaper and saving unattractive. With more consumers spending, higher demand for goods and services will cause prices to rise.
When inflation looks like it might get too high, Central Banks might want to unwind some of the economic momentum by raising interest rates. In theory, this makes borrowing more expensive and saving more attractive.
In the UK, interest rates have been incredibly low for the last decade following the 2008 financial crisis, as Central Bankers have tried to keep the economy stimulated.
This path to normalisation in the US and UK now looks like it may be faster and higher than expected, to adapt with the stronger economy.
How do interest rates impact equities?
Interest rates don’t impact equities directly, and they don’t always make stock market investments riskier. US markets have enjoyed the second longest bull market on record, against a backdrop of rising interest rates.
It’s a matter of market sentiment. At one end interest rates signal a healthy, growing economy; at the other it represents an economy that has peaked in this cycle and is going to constrict.
The latest set of economic data from the US and UK was a step too far for many investors as Central Banks have said they may adopt a more aggressive normalisation plan that could cause economic growth to tighten.
How interest rates impact businesses
Fundamentally, interest rates determine the price at which someone can borrow money, whether it’s an individual, company, bank or government.
On a consumer level, an increase in the cost of borrowing will make debt bills more expensive – whether it’s mortgage rates, or the interest on credit cards, for example. Higher bills eat into the amount of disposable income people have to spend – especially when you add in the impact of rising prices against stagnant wage growth.
Tighter consumer purse strings will translate into smaller revenue and profits for businesses. Companies are valued on their profitability, which means an expected reduction in future cash flows will be reflected in the price of the asset.
Companies also borrow money from banks. An increase in the cost of borrowing will also eat into profits and divert money away from any business expansion plans.
If a company scraps its plans to expand, the future cash flows investors had previously priced in will vanish, which will be reflected in the price.
How do interest rates impact bonds?
As a bond is a debt instrument, interest rates have a more direct impact on bonds that equities. When you invest in a bond, you’re repaid what you loaned and get an income from the coupon interest.
An investor measures the yield to gauge their potential annual return, which is calculated by dividing the interest by the value of the bond.
When interest rates rise, or are expected to, current bond prices fall. When interest rate fall, bond prices rise.
Interest rates tend to set the standard for bond coupons, so if the Bank of England increases the base rate, investors can expect to receive a higher coupon on a bond that will be issued in the future.
Investors want to get the best return they can, so they are likely to prefer the newer bond with higher interest to the current bonds.
This lack of demand causes bonds that have already been issued to fall in value, as investors look elsewhere for their income. As bond prices fall, the yield will increase, making it more attractive to the investor.
The opposite can be expected when interest rates fall.
What can you do
Short-term fluctuations in the value of your portfolio is rarely an easy thing to stomach, but it just highlights the need to invest in a way that’s suitable for you – preferably over the long-term.
If you’re going to need your money back within 18 months, investing probably isn’t for you. It’s not worth risking a bad performance if you don’t have the time to recover.
The longer you can invest the better. Not only does it give your money the greatest chance to grow, but it also prevents you from making potentially costly knee-jerk reactions.
Research from JP Morgan highlights this well. If you’d have invested in the American S&P 500 index in the two decades to 2014, you’d have made an annualised return of just under 10% a year.
If you’d have tried to time the markets and ended up missing just the top ten days of performance, this return would have slipped to just over 6%. Timing the market perfectly if a very difficult game to get right – even for the professionals.
It’s also important your investment portfolio reflects you and your financial background. If you need your money back in three years for a house deposit you’re going to be more risk averse than someone who is investing for their retirement.
A suitable portfolio should limit any losses during volatility and prevent you from any sleepless nights.
Volatility is normal
Remember, volatility is normal. It’s a fundamental characteristic of the financial markets that allow us to identify value opportunities and sell at a profit.
Reacting to recent volatility immediately is like someone who’s trying to see through blurred eyes just after waking up. It’s important not to overreact out of fear of the unknown.
The scene will get clearer and as you start to recognise the familiar shapes of the global economy and financial markets, you’ll be able to make the right decisions with the confidence that you see the full picture.
To react now would be like stumbling in the dark and stubbing your toe on your bed – potentially painful and full of expletives.