The performances of the Dow Jones 30, the S&P 500 index and the NASDAQ composite index have all turned south over the past 1 month. Market sentiment has soured on Wall Street, owing to a host of factors, notably central banks propensity towards rate increases. The relationship between interest rates and equities markets is clear: When rates rise, the cost of credit for listed companies increases.
This decreases profitability and has a negative effect on share prices. There are several theories why increasing interest rates are bad for equity markets – notably the higher costs that companies will be passing on to customers, and the increased yields in treasuries and fixed-interest-bearing securities other than equities. When loans become relatively more expensive to corporations, these companies tend to be less profitable, all else being equal.
The Winds of Change Are Blowing in Fast and Furious
The 1-year performance of the Dow Jones remains bullish at 19.63%, while the NASDAQ is up 26.08% over 1 year, and the S&P 500 index is up 15.54%. Across the Atlantic, there is far more reason to celebrate (at least in terms of percentage appreciation of bourses). The CAC40 is up 24.95%, the DAX 30 is up 31.53%, and the FTSE 100 index is up 12.51% over 1 year.
Equities traders have adopted a risk-off approach to markets in recent days. Ever since the Bank of England Monetary Policy Committee (MPC) meeting, there is more of an appetite for quantitative tightening than ever before. The recent vote (June 14, 2017) of the MPC reflected a 5-3 majority in favour of maintaining the bank rate at 0.25%. That there were 3 hawks is important. The BOE and central banks around the world including the European Central Bank, Bank of Canada, and the Fed have now shifted course and are looking to raise interest rates to rein in inflation, and help to stabilize economic growth.
Are Market Players Overreacting?
There have been sharp losses in tech stocks, which have been pounded by the risk-off approach. Tech stocks have seen the sharpest selloff in almost 1.5 years. As always with stock markets, it’s not 100% clear what precipitates a mass selloff among traders. For now though, it seems confined largely to NASDAQ-listed tech stocks, while financial stocks are trading at record levels. Fortunately, erratic trading behaviour is the norm for stock markets, and this tends to result in value-driven investments from traders looking for good deals.
Buying on the decline is common with stocks, and it results in rapidly escalating stock appreciations on the bourses. The current CBOE Volatility Index reading is 11.49, down 8.37%. Were it not for the incredible June jobs report figures showing an increase of 220,000 jobs, the volatility Index reading (VIX) would have been much higher. Reports from the Business Insider indicate that many traders were overreacting to speculation about central bank policy vis-à-vis rate hikes.
A Word from the Wise
Cornell H. McMaster of Trade-24 believes that there is no reason to go bearish on equities at this time. “The Fed will begin unwinding its $4.5 trillion balance sheet in due course. However, this is likely to be a gradual process. It will not be a sudden and dramatic decision that rocks financial markets. Even with central bank tightening around the world, we are looking at modest rate increases of approximately 25-basis points at a time. Markets will have plenty of opportunity to absorb these rate hikes and make accommodations for them. Any erratic trading activity on bourses should be perceived as an anomaly, not a long-term trend.”
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