It’s not as if we didn’t know it was coming. Jerome Powell could hardly have been clearer at the recent Jackson Hole summit that the Federal Reserve (Fed) will keep up the squeeze until the job is done. But sometimes it takes an event like this one to ram the message home. One after the other, central banks around the world, with the notable exception of Japan, are telling us the same thing. Interest rates are going up and they will stay there until inflation is back under control.
One by one, the guardians of monetary probity are abandoning cheap money. Either because they are choosing to or because a slumping currency is forcing their hand. Pretty soon the aberration of negative interest rates will be for the history books and normal service will have resumed. There will be a cost to borrow money and if you are lucky enough to have some to lend you will be rewarded for doing so. It’s a better place for us to be but getting back there after 15 years in the looking glass world of free money is going to be painful.
Hope springs eternal for investors, especially in the equity market where the default is to seek out the silver lining. But even for stock market investors the penny is now dropping. The next year or so is going to be tough for companies and investors during a period of deliberate demand destruction and rising costs. Somewhat belatedly, the buyers of shares – and in due course houses too, I suspect – are catching up with the bond market where people are temperamentally more inclined to see the cloud wrapped round that silver lining.
One of the notable features of the post-financial crisis era, and a key driver of the long bull market in shares, was the maintenance by central banks of negative real yields. Keeping bond yields lower than the expected rate of inflation was explicitly designed to drive investors into riskier assets in search of acceptable returns. If you were losing money in inflation-adjusted terms by holding cash or bonds, it was logical to shift your money into shares.
Real yields fell deep into negative territory during the pandemic as inflation expectations rose while central banks kept interest rates, and so bond yields, artificially low. In recent months, two things have happened to dramatically reverse that situation. First, as we know and as the recent announcements are confirming, central banks have relearned their primary purpose. Second, inflation expectations have started to tumble as investors have understood what that policy shift means – recession may not be the desired outcome but it will be an acceptable one to independent central banks if that is what it takes to knock inflation on the head.
With inflation still in the high single digits on both sides of the Atlantic, it might seem implausible that inflation will fall back to the central banks’ targets but that is what the financial futures markets are implying. A measure of what investors expect inflation to be in 10 years’ time, derived from the difference in yield between inflation-linked and nominal bonds, has fallen in just five months from 3pc to 2.4pc. Investors are starting to take central banks at their word.
At the same time, investors now expect the recent interest rate hikes in the US to continue for the foreseeable future. By next spring, US interest rates are forecast to have reached 4.4pc. Bond yields now reflect this reality, with the income on bonds maturing in two years’ time now at 4pc. Far from keeping bond yields well below the expected rate of inflation, they are now well above. The squeeze is real in every sense of the word.
This increase in real yields matters to stock market investors because it is a key input into the valuation models that are used to determine what is a fair value for a share, or indeed the market as a whole. It has a particularly negative impact on those shares that are expected to deliver lots of growth over many years because that future growth in earnings is worth less in today’s money when it is ‘discounted’ back using a higher real yield.
The US stock market is currently valued at around 16 times expected earnings, but today’s higher yields make a valuation multiple of between 14 and 15 look more realistic. Shares have fallen hard so far this year, but this suggests that the reset is not quite over yet. A further decline of about 10pc to 3,500 for the S&P 500 index looks plausible. The fall will be amplified if the current reduction in earnings growth expectations has also not yet run its course. I would not be surprised if 2022 turns out to be the worst year for stock markets since 2008.
What can investors do about this? Not a lot, I would suggest. Finessing a 10pc move in the stock market is not a realistic proposition for a couple of reasons. First, the cost of moving in and out of the market will eat into the potential benefit of watching the final move lower from the side lines. Second, trading a market low requires two decisions not one – selling and then buying back in. Human nature being what it is, most of us will fluff that second call.
The best approach during this bottoming phase of the market is to be patient. To consider remaining invested and, indeed, to steadily and systematically put money to work at what, in due course, may look like attractive market levels.
