Equities & Interest Rates
Last week Equity Mutual Funds (in UK we refer to such funds as Unit Trusts) around the world attracted their biggest weekly inflows of investment money in more than a year, as investors grow increasingly confident that Central Banks will support financial markets with looser monetary policy.
Such investment inflow reflects an appetite for risk as the world’s central banks continue to adopt an increasingly ‘dovish’ outlook. The US Federal Reserve on Wednesday held its key ‘Fed Funds’ rate unchanged but signalled that it would be open to a cut next month (compare this to the situation last December when the market expected 3 quarter point rises in the Fed Funds rate in 2019 – we have had none!).
This rate cut is now widely anticipated with Fed Funds futures prices suggesting an 80 per cent chance that the US Central Bank will cut rates by 25 basis points (0.25%) in July.
In Europe, Mario Draghi, president of the European Central Bank, announced this week that the Frankfurt-based institution could consider expanding its EUR 2.6 Trillion bond-buying programme (i.e. injecting funds into the economy) to help increase inflation across the 19-nation Eurozone.
At the Bank of Japan too, governor Haruhiko Kuroda, indicated this week that extra stimulus would be an monetary option.
Such a low interest rate outlook goes down well with stock markets.Why?
- Low interest rates should boost economic growth and therefore company profits
- Low interest rates reduce the cost of company borrowing e.g. if IBM can issue a 10-year bond with a 2% coupon rather than a 4% coupon that directly impacts the company’s profits
- Low interest rates makes equities a relatively more attractive investment compared to bonds i.e as above, if bonds only pay, say, 2% interest instead of 4% interest they become relatively less attractive to investors compared to investing in stocks.
As a result, stock markets globally are well supported right now with the main US S&P 500 index of the largest US public companies hitting a record high this week. This stock market benchmark is up almost 18 per cent for the year after suffering a sell-off in December, driven in part by hawkish comments from Federal Reserve chairman Jay Powell (when three 2019 interest rate rises were expected) that spooked the markets. The FTSE All-World Index, which tracks the world’s largest companies, is up 15 per cent for the year.
Looking ahead, conditions may reflect a Goldilocks environment with dovish central banks, continued growth and muted inflation. One danger to this scenario is the ongoing US/China trade talks but the markets expects resolution of this issue one way or another.
How does this low interest rate outlook affect non-equity asset classes?
- Bonds – Yields have been driven lower. The yield on the key US 10-year Government Bond is trading at just under 2% Yield-to-Maturity. Compare this to the circa 3.25% YTM at the start of the year! Remember yields down means bond prices up! In Europe, bond yields have also plummeted with the yield on the key European 10-year German government bond at a negative -0.33% YTM. Even in the UK, the 10-year Government Bond only yields 0.80% YTM.
- US Dollar – Low US interest rates makes the prospect of investing in dollar assets less attractive so the dollar has weakened.
- Gold – Gold, as a physical asset, has intrinsic value and is priced in dollars per ounce. So if the dollar falls, all other things being equal, the price of gold should go up, and it has! Gold is now at a six-year high of $1,440 an ounce.
- Oil – The oil price is unrelated to global interest rate movements but if low interest rates imply slow global growth then this implies weak demand for oil. However, Middle East tension, a major oil producing region, is quite high now which supports the oil price as supply from this region is threatened. Oil is in mid-range territory at 65 dollars per barrel.
The Goldilocks scenario continues!
Equities
S&P 500: 2930
Nasdaq: 8000
FTSE 100: 7400
Bonds – 10 Year Government Yields
US 2.00%
EU -.32%
GB 0.80%
Foreign Exchange
EUR/USD 1.1400 (1 euro buys 1.1400 dollars)
GBP/USD 1.2700 (1 pound buys 1.3200 dollars)
Commodities
OIL: Brent: 65.00 (dollars per barrel)
GOLD: 1440 (dollars per ounce)
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