The beginning of the year started with a market reorganization, and this trend is expected to continue to dominate in the coming period. Just because of the news of the Fed’s interest rate hike.
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In response to the downturn caused by the coronavirus, many countries have introduced stimulus measures. A key step was to start printing money and, if there was still room, to lower the base rate of the central bank.
Among these countries were the United States and China, which account for a significant part of the world economy. In this way, large amounts of money were injected into the economy either virtually interest-free, i.e. almost free, or completely free.
You don’t need to be an economics guru to see that there will be consequences of spending a globally huge amount of money.
That consequence has appeared. What money could not be spent, it has sought and found a place for itself, in many cases in equities.
This made sense, as investors were getting little for bonds in the low yield environment. They could have chosen to spend it, but the quarantine and global supply disruptions are only partly remedied by the money.
Once the quarantine was lifted, inflation started to kick in as buying took off. This was good for the US, which was already suffering from deflationary problems, but now they think it is a bit much. That is why the Fed’s announcement suggests that it could raise interest rates as much as 3 times this year. This in itself is probably very welcome, so the question is what it has to do with you as an investor.
Let’s take a look at what’s expected this year.
If you want to invest in shares, you should apply the same principles to buying a single share as you would to buying the whole company. After all, the only difference between the two is the amount of money you invest and the influence you get in return, the market performance and environment of the company is independent of you.
Share prices were sky high for a reason. The bond market is much larger than the equity market, but given that the twin factors of high inflation and low base rates mean that investors are not getting enough for their money to at least hold its value, so the capital invested here is looking a place elsewhere.
What you can observe in the stock market
In the January overview, it was already said that the shares, previously known as quarantine shares, had already been replaced by companies offering products and services that could be used offline.
This rearrangement continues.
Stock market downturn
In 2021, the stock market has seen an unprecedented rise, thanks to new capital inflows and an otherwise low yield environment. But this trend looks set to reverse. The news of the Fed’s interest rate hike and its basically tighter communication has not only stalled growth, but also led to a major downturn at the beginning of the year.
Of course, it is impossible to tell from the events of a single month whether this is a correction, a trend reversal or a harbinger of a major crisis.
What could play a role is the aforementioned interest rate hike. This has two effects.
The impact of the bond market on equities
In the past, bonds have underperformed inflation, which is why some of the money in bonds is now in equities. Now that the real interest rate may be positive again, this capital is flowing back out of equities and into bonds. And falling demand will also reduce the price of equities.
Impact of higher interest rates on companies
Higher central bank interest rates also mean higher lending rates. This is true on both the retail and corporate side.
This makes it either harder or more expensive for firms to obtain credit, or harder and more expensive for them to obtain finance. Whatever the case, they are faced with the fact that improvements and production expansion are not necessarily being made now.
There are high-value products that people have bought primarily on credit. As harder credit becomes more difficult to obtain on the retail side, this means a harder-to-sell product in the lives of companies.
Both branches will result in them being less profitable.
Previously, bonds were recommended for moderate risk and short to medium term for decades, this textbook form was modified by covid. After inflation caused investors to earn negative real returns on them, much of the money held in this instrument moved elsewhere, partly into equities.
The Fed’s interest rate hike should change this and perhaps restore order. Newly issued bonds are now quoted at a higher interest rate and those already on the market are priced at that higher rate. For more on the reasons for this, see the section on duration.
As you can see, this process has already started, with US 10-year government bond yields rising since the beginning of the year. And that’s just the beginning of the process, if you look at the next picture you can see that looking back 5 years there is definitely still room to rise.
One of the consequences of this could be not only to curb inflation, but also to stimulate the bond market. In fact, once investors achieve a return above inflation, i.e. a positive real return, they can return the money they had previously invested in equities back to the same place.
This will lead to a recovery in demand for bonds, which in turn will mean a fall in the price of equities.
Where can you invest?
Of course, in an environment where prices are high globally, you can draw from a much narrower range than at the beginning of the up phase.
Which area is right for you depends on a lot of things. From the time horizon available to you, to your own risk tolerance, to your own preferences, practically everything can intervene. So here and now, we’ll just look at what you should consider.
For equities in particular, it is true that over a time horizon of more than 10 years, it is the investment strategy that can be the deciding factor for you. After that time, the current high share price will no longer be considered high, similar to the way you can look back at any time and find peaks in share prices, after which the economy continued to grow.
For other investment classes, market cycles and potential maintenance costs are different and distort this picture, so inform yourself accordingly.
Short and medium term investment
Within this time horizon, the individual characteristics between the papers of different companies are more pronounced, so that papers that are better adapted to the current high inflation environment are more prominent.
Staying with equities, there are typically two directions you can go in a high inflation environment.
The company’s capacity is not fully used
One way is if the company’s capacity is not fully utilised and there is demand for its products. Demand, I might add, that cannot be met elsewhere. These are firms that can raise prices with virtually no consequences. By doing so, they not only track inflation, but they remain stable, they can grow, and even pay higher dividends.
But how can a company do that?
Logically, people would look elsewhere for a similar product as a result of the price increase.
This has already been discussed in the article on the questions before buying shares. Specifically, whether the company has a stable, sustainable competitive advantage.
If they have a well-established brand that you and other consumers can use to explain why to choose it, then your livelihood is secure, otherwise it is a fact that most consumers will look for other, so-called substitute products. An example of a well-constructed brand might be Apple or Coca-Cola.
No large capital investment is required for growth
The other case is when you can increase your capacity, and therefore your revenues, without major capital investment.
These are typically technology companies. It is easy to see that Google can increase the number of units of its service far more easily than, say, a car company.
But what is happening in technology companies is that many of them performed well during the quarantine period and are now experiencing a downturn.
There may still be some that are good buys, but be prepared to consider the combined effect of two effects.
What to expect? (Is a crisis really expected?)
Whether there will be a crisis is obviously unknown. Sooner or later, it is certain, but whether it will happen this year is unknown.
But two things can give us a clue.
Oil is not only important for fuels. It is used in heating, in the production of plastics and many other applications.
Although much effort was made around November to bring oil prices to around $60, which is good for the global economy as a whole, this effort did not produce lasting results.
This, if it does not change, will continue to imply a high inflationary environment, as this will be factored into the price of all goods and services that have any connection with oil.
However, the price of this asset is already showing better news.
Gold, as a way for people to get their money here in times of uncertainty, is now sideway. In other words, there is no significant recovery in demand.
This recovery could be observed to some extent if you take into account that many people are already using “digital gold”, i.e. a cryptocurrency, for this purpose, or perhaps prefer other precious metals (e.g. silver).