There is nothing difficult about investing. You simply need to understand what drives markets. Many people consider the principal driver to be interest rates, which influence a country's economic performance. The health of the economy determines profits. The level of profitability will affect how shares behave. So if you know what is likely to happen to interest rates, then you should have a pretty good idea of what the stockmarket will do.
The future direction of interest rates is an interesting call on both sides of the Atlantic. Once upon a time Governments made the decision on whether to raise or lower the cost of money. Now it is increasingly the preserve of central bankers. It was Gordon Brown who charged the Governor of the Bank of England or more correctly the Monetary Policy Committee with the task of setting interest rates, giving low inflation as its target. This has allowed him to apologise to manufacturing industry for the strength of the pound, saying there is nothing he, as Chancellor, could do about it. Nor can the MPC for that matter. A strong pound, undoubtedly helped by the high level of interest rates, helps keep inflation in check.
In the US Alan Greenspan has an altogether wider remit, but inflation is presently his greatest concern. The continuing robustness of the US economy should, on the evidence of past experience, have a knock on effect on inflation. Trying to take some of the steam out of the economy is why the Federal Reserve Bank has been pushing up interest rates. But Alan Greenspan will react to other factors as well. US interest rates were cut when world stockmarkets went into a spin during the summer of 1998. You have to realise that these days markets are more powerful than governments.
But if history tells us that interest rates are crucial in determining the direction of markets, you should also realise that the world is changing. Interest rates and the yield on bonds have always been considered to be closely tied together. Yet in this country we have an inverted yield curve - that is to say longer dated Government bonds yield less than short dates. The yield on shorter issues is certainly influenced by the prevailing level of interest rates, but for longer bonds there is a scarcity value.
Gordon Brown believes you should balance the books. So the Government is borrowing less money and the supply of bonds has diminished. We have a large pensions industry and there is a ready demand for gilt edge stocks to meet the Government-set Minimum Funding Requirement standards. Yields at the long end have been driven down, which is why annuity rates are so low at present.
Nor is this the only change in the market conditions. The technology bubble has proved that old rules need not apply. While there is every indication that this particular over-inflated balloon is suffering a little deflation at present, the growth of this sector has been phenomenal and accomplished with little of the demand for capital that previous commercial revolutions - such as the expansion of the railways - have required. Moreover, there is the low inflation environment. This has been helped by the technological revolution and prudent finance ministers.
We cannot rely upon cycles to be so predictable in the future. It is true that rising interest rates should slow the economy, which in turn could mean lower returns from equities. But these days many more things have to be taken into account, including the attitude of international investors. At least the MPC - and the Federal Reserve Bank in the US for that matter - are trying to anticipate problems rather than react to them, but it may no longer be a case of selling equities if interest rates rise.
The MPC's decision not to move interest rates this week may prove a temporary respite, but equally the volatility of the technology market could be more of a determining factor. One thing is for certain. While a low inflation environment should make bonds attractive, so deeply is the cult of the equity ingrained into the psyche of the average investor that this may no longer hold true.
So watch interest rates, but don't rely on them as such a reliable signal.
Brian Tora is Chairman of the Greig Middleton Investment Strategy CommitteeReuse content