Investment: Sensing changes ahead in balance of risks
Wednesday 26 May 1999
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.
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