So the FTSE WAS down 10% (NOW 5 OR 6%) in a matter of days? Oh well.
It’s not the response that you might, expect especially from a financially trained person such as me. But I do mean it. I have two reasons for being laid back: it’s a technical adjustment and the prospects for shares remain good.
The technical reason for the decline is, er, good news. The good news – that US job creation is proceeding apace – means that its central bank, the Fed, will probably raise interest rates. If it raises interest rates then not only will a lot of companies’ earnings decrease as they pay more interest, but the Net Present Value of their earnings will be less. The Net Present Value (“NPV”) is the value to-day of money (in this case dividends from these companies) received on the future. It’s the inverse of putting money in the bank deposit account. Money deposited in a bank will grow (just!) by the interest rate paid. Money yet to be received can be equated to that deposited amount’s value in the future (together with its interest) by discounting it back to to-day by the interest rate on the deposit. So the adjustment in share prices is technical, the result of everyone doing these sums and reaching the same answer: an increase of say 0.25% in interest rates will reduce the NPV of future income streams.
But it won’t significantly alter the prospects of these businesses, after all it’s only a small increase in interest rates. What would alter values significantly is larger movements in interest rates and these are extremely unlikely. My reasoning is that we can’t afford it. By that I mean that the level of debt in the world since the financial crash is extremely high, especially in the UK and USA, and an increase in interest rates here would have severe implications. Not only would mortgage holders reduce expenditure but increased interest payments by these Governments would mean a reduction in expenditure on other things. A recession would inevitably ensue.
By holding back on interest rate rises, inflation seems inevitable. While seen for a generation as a spectre to be avoided, it’s now the least worst option, which will reduce the real value of all that debt. It will also increase the value of shares: if costs go up 10% so do sales prices, and therefore profits.
If interest rates aren’t going to rise, what will central banks do when interest rates need to fall, because there is a recession arising for another reason? Reducing interest rates stimulates an economy that has low levels of demand. If they are already low then it’s very difficult to lower them further; the experiment in Japan with negative interest rates (i.e. if you deposit money you will get less back than you put in) was not especially successful. I’m not surprised. However solid the theory is, it’s just weird. What seems increasingly likely to happen is more QE (quantitative easing) i.e. printing money. This has the same primary effect as lowering interest rates – it makes money cheap because there is more of it rather than it being cheaper to borrow – but has a secondary effect of increasing asset prices such as shares.
So while movements in interest rates and inflation will mean rises and falls in share prices day to day, the fundamentals point to shares being the best place to invest.