October has been a poor month for investors. Nervousness set in after the US Federal Reserve raised interest rates, as expected, in September but spoke quite firmly about the need to increase rates by more. At the same time, the yield on three-month US Treasuries (a proxy for cash) rose above inflation for the first time in a decade. US investors, if not the rest of us, now have other options for investing, apart from in equities.
Higher interest rates themselves are not necessarily a problem if economies are growing strongly, but together with the reversing of quantitative easing in the US (the Fed is reducing its stock of purchased bonds), does represent a tightening of liquidity conditions. This means less “firepower” to keep buying equities. At the same time, higher bond yields have increased the discount rate applied to future company earnings, thereby reducing their present value. This has put downward pressure on the share prices of highly rated growth stocks. Meanwhile, economic growth (outside the US at least) has been slowing, while many companies are experiencing higher costs as wages rise and energy prices go up.
We took the view that this was a market correction rather than the start of a more prolonged downturn. Global economic growth, albeit slowing, is still likely to be healthily positive over the next year or so. Meanwhile, equity market valuations are not elevated and are now looking cheap in some places. Corporate earnings and dividends are still forecast to grow. Furthermore, any signs of weakness in the US economy will likely temper the Fed’s enthusiasm to raise interest rates in the future, thus providing a counterpoint to the events that kicked-off the fall in stocks in the first place. Volatility may be back, but it doesn’t mean that the current bull market is over.
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