If we listen very carefully, we should be able to detect a strange popping noise in the market that we probably haven’t heard for quite a while. This is the sound of bubbles bursting as overvalued assets implode from the threat of higher interest rates. Thing is, for the last decade or so, asset prices have been almost a one-way bet.
We could buy any old rubbish peddled by snake-oil merchants and expect them to rise. Their prices have been supported, though some might even say pumped up, through ultra-low interest rates and very generous monetary policy. Does anyone remember meme stocks? What about cryptocurrencies and spurious non-fungible tokens?
But at the end of the day, asset prices are a function of interest rates. Consequently, when interest rates were gradually reduced, the value of assets tended to rise. It’s not rocket science. But the converse can happen as interest rates start to rise.
The attraction of bonds
Consider a bond investor who has bought a bunch of fixed-rate instruments. These investments pay a fixed coupon twice a year. When prevailing interest rates were on the way down, investors were willing to pay more for the coupons that those bonds promised to pay. Who can blame them?
As a result, bond prices rose. However, when interest rates are on the way up, those fixed coupons start to look a lot less attractive. One day they might start to look attractive again. But that is not going to happen until bond prices fall to a level that make them more appealing again. How far they fall will depend on how high interest rates might rise.
Some experts think that US interest rates could increase four or maybe five times this year. Others have even gone even further by speculating that the US Federal Reserve could raise interest rates seven times this year. Your guess as to how many and how quickly interest rates could rise is as good as mine.
Markets hate uncertainty
It all depends on just how bad inflation could get. And thereby hangs a tale. The latest inflation data from the US was jaw-droppingly bad. The inflation rate of 7.5 per cent, which is the highest for 40 years, was worse than the market had expected. Some economists think that the surge in prices is due to disruptions to supply chains, as countries around the world start to reopen. They think that the high inflation rates we are witnessing are just an aberration.
They could be right. Therefore, as normal service resumes to something that might resemble normality, the inflation rate could start to moderate, too. Other experts think that the inflationary pressures we are witnessing are the result of years of easy monetary policy.
We can argue the toss about the causes of inflation to our heart’s content. But what is clear is that the rhetoric at central banks has changed, which is likely to create greater uncertainty in global markets. And as we well know, markets hate uncertainty.
So, what should investors do? It is really quite simple. We have to identify a focal point against which our investments can be measured. For instance, astronomers have long known that the North Star is a reliable point in the sky for navigation. In a similar way, investors can use cash flow or earnings as their reliable lodestar. It is much better than share prices that can be distorted by investor sentiment.
Income investors can always use the dividends generated by their portfolios as their guiding light. As an unashamed dividend-focussed investor, I closely monitor the income generated by my portfolios.
With the right combination of shares, those portfolios could deliver a reliable stream of rising payments, regardless of volatility in the markets. What’s more, the sound of dividend cheques popping into a bank account is so much more pleasant than the popping sound of bubbles bursting in the market.
Note: An earlier version of this article appeared in The Business Times.
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Disclaimer: David Kuo does not own shares in any of the companies mentioned.