Investment: Sensing changes ahead in balance of risks

THE HARDEST thing of all to do in financial markets is to call a turn in the key economic indicators, such as inflation or interest rates. You have to be either a mug or a masochist if you think that you can get them right with any degree of precision, which is why most of those who make those calls only do so when they are being paid a lot of money to stick their neck and risk getting egg all over their face.

The best technique, one of those well-paid market mavens once told me, is to "forecast long and forecast often". That way, with any luck, if you are wrong, nobody will be able to remember just how wrong you were. And if by any lucky chance you prove to be right, you have a choice of baselines from which to demonstrate how good your forecasting has been. Does that sound too cynical? I hope not. It is meant to be a realistic assessment of the state of the forecasting business. The truth is that it is rarely difficult to identify which variable is the key parameter in the market outlook at any one time. What takes time and good fortune is to identify in which direction that parameter is likely to go next. In most cases, experience suggests, the simplest and safest method is to assume that the current trend, whatever it is, will continue into the near future.

Thus, for example, at almost any point in the 1990s, anyone who assumed that the level of inflation and interest rates would continue to fall would have discovered a very workable investment strategy. The reality is that the downward trend in both variables has been the single most outstanding feature of the investment climate in the decade. On the time- honoured basis that for investors the trend is your friend, it would be unwise to assume that this trend will reverse until or unless there is some clear evidence that it has run its natural course.

But there is little doubt that we have now reached a genuine decision point as far as global interest rates are concerned. Even those of us who have successfully championed the buying of bonds as an asset class in the 1990s are now forced to contemplate whether or not that game has finally had its day. I am not referring to the next movement in short- term interest rates, which remains a largely parochial issue, but to the far more important movement in long-term interest rates, as reflected in the yield on long maturity bonds.

The question of whether long-bond yields have bottomed out has been asked at repeated intervals throughout the decade. There were those who thought that the bottom had been reached in 1994, when a surprise move by the Federal Reserve to tighten policy left many professional investors nursing hefty losses on their bond holdings. In fact, viewed from the comfort of today's perspective, it proved to be a mere blip on the historical interest rate charts. According to Barclays Capital, the data shows that global interest rates, as measured by bond yields, have fallen steadily to new lows in 1998. Any satisfaction that the UK might have taken from the fact that interest rates have fallen so sharply in the last decade is tempered by the realisation that in real terms, we suffer from some of the most lowly rated government bonds of any country in the world (Greece and Italy included).

The significance of falling long- term interest rates lies in a simple mathematical formula. Whether you are talking about the value of a stock market as a whole, as market strategists like to do, or about a particular company's shares, the value of any financial asset can be found by a simple equation, of the form x = y/z.

The top line in the equation (the `y') is the expected future stream of profits or dividends that you expect to accrue to the investor. The bottom line (the `z') is a rate of interest that represents the long- term opportunity cost of investing in that future stream of income. Divide one by the other and in principle you have the intrinsic value of the investment you are thinking of making - a benchmark against which you can compare the current price at which you are being asked to invest. In practice, of course, this simple sounding formula is impossible of precise evaluation: if everyone knew for certain what a market's future earnings were going to be, and/or the level of interest rates which would prevail over say the next 10 years, there would be no need to have financial markets at all.

What has happened, in very broad terms, over the last 15 years of bull market conditions is that both the top and bottom lines of the market valuation equation have risen together. Company profits and dividends have risen (from an initial very low base in the 1970s) while interest rates have also fallen steadily from their very high levels at the start of the 1980s. The question now is whether that long and beneficial secular trend has come to an end.

The Federal Reserve has this week given us a clear signal that its policy of accommodating the stock market boom in order to secure wider economic goals (such as the stability of the financial system) is nearing the end of its course. The long bond yield in the US is now well above its low point of last year, and the trend looks set to be followed elsewhere in the world.

Only a fool, or a Midas, as I said at the outset, would want to give a definitive call about whether the interest rate decline is over for all time. But my sense is that the balance of risks in most countries is now against the trend of the past 15 years continuing for much longer. It will be great if it does, but the prudent investor, I suggest, will be starting to prepare strategies for countering the alternative outcome.

Start your day with The Independent, sign up for daily news emails
The Aviva Premiership trophy
rugby union All the latest from Twickenham
Life and Style
Aston Villa manager Tim Sherwood
footballDanny Higginbotham: Tim Sherwood must play game of two halves to cause major upset
Caber is trained to help child victims of serious crimes testify
ebooksAn unforgettable anthology of contemporary reportage
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Guru Careers: Pricing Analyst

£30 - 35k: Guru Careers: We are seeking a Pricing Analyst to join a leading e-...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + OTE £45K YR1: SThree: At SThree, we like to be dif...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + competitive: SThree: Did you know? SThree is a mul...

Guru Careers: C# Project Team Lead

£55 - 65k (DOE): Guru Careers: A unique opportunity for a permanent C# Develop...

Day In a Page

Fifa corruption: The 161-page dossier that exposes the organisation's dark heart

The 161-page dossier that exposes Fifa's dark heart

How did a group of corrupt officials turn football’s governing body into what was, in essence, a criminal enterprise? Chris Green and David Connett reveal all
Mediterranean migrant crisis: 'If Europe thinks bombing boats will stop smuggling, it will not. We will defend ourselves,' says Tripoli PM

Exclusive interview with Tripoli PM Khalifa al-Ghweil

'If Europe thinks bombing boats will stop smuggling, it will not. We will defend ourselves'
Raymond Chandler's Los Angeles: How the author foretold the Californian water crisis

Raymond Chandler's Los Angeles

How the author foretold the Californian water crisis
Chinese artist who posted funny image of President Xi Jinping facing five years in prison as authorities crackdown on dissent in the arts

Art attack

Chinese artist who posted funny image of President Xi Jinping facing five years in prison
Marc Jacobs is putting Cher in the limelight as the face of his latest campaign

Cher is the new face of Marc Jacobs

Alexander Fury explains why designers are turning to august stars to front their lines
Parents of six-year-old who beat leukaemia plan to climb Ben Nevis for cancer charity

'I'm climbing Ben Nevis for my daughter'

Karen Attwood's young daughter Yasmin beat cancer. Now her family is about to take on a new challenge - scaling Ben Nevis to help other children
10 best wedding gift ideas

It's that time of year again... 10 best wedding gift ideas

Forget that fancy toaster, we've gone off-list to find memorable gifts that will last a lifetime
Paul Scholes column: With the Premier League over for another year, here are my end of season awards

Paul Scholes column

With the Premier League over for another year, here are my end of season awards
Heysel disaster 30th anniversary: Liverpool have seen too much tragedy to forget fateful day in Belgium

Liverpool have seen too much tragedy to forget Heysel

Thirty years ago, 39 fans waiting to watch a European Cup final died as a result of a fatal cocktail of circumstances. Ian Herbert looks at how a club dealt with this tragedy
Amir Khan vs Chris Algieri: Khan’s audition for Floyd Mayweather may turn into a no-win situation, says Frank Warren

Khan’s audition for Mayweather may turn into a no-win situation

The Bolton fighter could be damned if he dazzles and damned if he doesn’t against Algieri, the man last seen being decked six times by Pacquiao, says Frank Warren
Blundering Tony Blair quits as Middle East peace envoy – only Israel will miss him

Blundering Blair quits as Middle East peace envoy – only Israel will miss him

For Arabs – and for Britons who lost their loved ones in his shambolic war in Iraq – his appointment was an insult, says Robert Fisk
Fifa corruption arrests: All hail the Feds for riding to football's rescue

Fifa corruption arrests

All hail the Feds for riding to football's rescue, says Ian Herbert
Isis in Syria: The Kurdish enclave still resisting the tyranny of President Assad and militant fighters

The Kurdish enclave still resisting the tyranny of Assad and Isis

In Syrian Kurdish cantons along the Turkish border, the progressive aims of the 2011 uprising are being enacted despite the war. Patrick Cockburn returns to Amuda
How I survived Cambodia's Killing Fields: Acclaimed surgeon SreyRam Kuy celebrates her mother's determination to escape the US

How I survived Cambodia's Killing Fields

Acclaimed surgeon SreyRam Kuy celebrates her mother's determination to escape to the US
Stephen Mangan interview: From posh buffoon to pregnant dad, the actor has quite a range

How Stephen Mangan got his range

Posh buffoon, hapless writer, pregnant dad - Mangan is certainly a versatile actor