A line has been crossed - echoes of 1987

Fri 26 Oct 2018

By Brian Dennehy

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Market commentary

A very important point was reached in the last week, and no one noticed (almost no one). It’s certainly not complex. Nor is it technical. It is very basic. But it is something which the central banks didn’t want you to spot!

A very important point was reached in the last week, and no one noticed (almost no one). It’s certainly not complex. Nor is it technical. It is very basic. But it is something which the central banks didn’t want you to spot!

It is old news that in 2008/9 the central banks around the globe (led by the Federal Reserve) took unprecedented action. Zero interest rates (ZIRP) and quantitative easing (QE) were launched along with a fleet of other acronyms, and a flotilla of grand names with initial caps, to save the world from Great Depression II.
It worked. But it continued years beyond the point when it was necessary, and an ugly price will likely be paid. Before getting to that, it is worth remembering that no investment decision is (or should be!) made in isolation. It is a choice. You choose between a range of options and, fingers crossed, you choose the one which has the greatest potential for you, particularly bearing in mind your risk tolerance – your ability to cope with the daily ups and downs.
One factor which you typically take into account is the level of interest or dividends generate by those choices – ideally you want it to exceed inflation. In 2008/2009 the central banks began reducing interest rates to zero, and one stated objective of doing this was to make some investment or saving choices unattractive, and encourage people to take more risks to achieve a higher income.
For many investors it was a TINA moment. There is no alternative to the stock market. I should say “was” no alternative – a line has been crossed in the last week.
The increase in US interest rates (slowly reversing the ZIRP policy) now means that the interest yield on 3 month Treasury bonds (2.29%) is now above the level of US inflation measures (2%-2.2%) for the first time since the Great Financial Crisis. These 3 month bills or bonds are a proxy for cash deposits - for ease think in terms of building society deposit rates in the UK. It means you can get a real return, that is make a gain after allowing for inflation.
That is a big issue for a lot of investors ordinarily. All the more so now. In particular the 3 month bond is risk-free in stark contrast to a US stock market which appears to be starting a long-awaited correction – and odds are shortening on that turning into something somewhat more ugly.
Plus the yield on those risk-free bonds is above the dividend yield on the US stock market (a mere 1.95%). 
The latter has been the case since the Spring. You shouldn’t expect an instant response when such indicators flash – you just go on your guard – annoyingly, the market will respond when it is ready, and not before.
Last but not least, there is a rhyme with the period just before the Crash in 1987. To paraphrase from my “Short History Of The Great Crash 1987”…
…Let’s give this perspective. The long term return from the stock market is about 10% per annum. The stock market has just enjoyed an outsize return of 60% since the 2016 low. Now risk-free bonds offer you a government-guaranteed return higher than inflation and higher than the yield on the stock market. Hmmm. What would you do?


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