Like any chemistry teacher will tell you, equilibrium isn’t always the optimum state. It can lack energy, opportunity and excitement. The relative calm of equity markets over the last few years may have led to happy investors, but it was driven by artificially low interest rates and, at some point, something had to give. It certainly looks like the so called “Goldilocks” era of moderate growth and easy conditions is coming to an end, and we think investors should prepare themselves for a period of higher volatility. But as we will explain, that’s not necessarily bad news.
Bond yields on the march
There are several factors pushing bond yields off their record low levels. Primarily, it’s a change in supply and demand. A year ago, central banks were buying $3bn worth of bonds per day, but this has started to reverse so that by the end of this year they will be selling $2bn a day. Because of this change in monetary policy, bond yields continue to rise and are threatening the relative attractiveness of riskier assets. Analysts are predicting US Government bond yields could reach 4% – levels not seen since 2010 – and equity investors are understandably nervous. This is further fuelled by President Trump’s borrowing frenzy, taking US deficit levels to new highs (or lows, depending on which way you want to look at it).
Rising global inflation and interest rates
In the meantime, there are several inflationary forces adding fuel to the fire: President Trump’s spending and tax-reduction policies; low global unemployment giving rise to real wage growth; and a robust economy. The price of oil is on the rise, trading at $75 a barrel – the highest it has been for four years, and defying those who predicted it would never rise beyond $50 again (more on that later). With global inflation rising, central banks will be forced to increase interest rates. Nobody knows how the rising cost of debt will affect asset prices, but it makes for uncertain times for equity markets.
The Sanlam view
We’ve been anticipating this scenario for some time, and our cautious position on government bonds and equities has so far paid off. Looking ahead, while it’s right to be vigilant, we think the underlying global economy can withstand these changes, and a normalisation of interest rates and inflation is good in the longer term. Interest rates are still at historically low levels and have a long way to go before they impede economic growth. If anything, we think the recent developments are positive, as they reassert a focus on the fundamentals and we are now seeing more value in the market than we have for years. Our philosophy is to focus on quality businesses with low levels of debt, which should mean our investments are well positioned for rising interest rates.
“Market volatility is back on the agenda. While all change brings a degree of uncertainty, we believe that over the longer term a shift back to focusing on business fundamentals can only be a good thing.
We continue to be guided by our forwardlooking high quality approach – investing in well run businesses with low levels of debt. This means we are well positioned to weather market movements in an environment where interest rates are on the rise.” - Philip Smeaton, Chief Investment Officer
Investment view: Why the price of oil still matters
Historically, the price of oil has played an important role in world economics, driving economies into recession and countries to war. But does this so-called ‘liquid gold’ still yield such power?
As the graph shows, oil prices and inflation remain inextricably linked, so the fact that oil prices are on the increase should mean that inflation picks up, supporting the outlook for higher interest rates.
Like anything, the price of oil comes down to supply and demand. On the demand side, India and China are growing rapidly, and overall volume growth is set to remain strong despite optimism that electric vehicles will drive the opposite trend.
On the supply side, growth in shale oil production is yet to keep up and needs further pipeline infrastructure investment to bring it efficiently and effectively to market. Meanwhile, Saudi Arabia is restricting supply as it looks set to list 5% of Saudi Aramco (a state-owned oil company) towards the end of this year and wants to keep oil prices elevated at least until that happens.
As a result, demand is outstripping supply, global stockpiles of oil are being rapidly depleted, and the price of oil is on the increase. This looks set to continue, as a lack of investment in exploration and drilling throughout the downturn means the major oil producers will take time to bring more oil to market. In the meantime, the trend of increasing oil prices, and therefore inflation and interest rates, could continue for several years.
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This article is for information purposes and should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed above are based on information received from a variety of sources which we believe to be reliable, but are not guaranteed as to accuracy or completeness by Sanlam Private Wealth. Any expressions of opinion are subject to change without notice. Reproduction of this commentary is not allowed in whole or in part without prior written agreement from ‘Sanlam Private Wealth. Past performance is not a reliable indicator of future results. Investing involves risk. The value of investments, and the income from them, may fall as well as rise.