Investor An insider's guide to the marketThe US first-quarter earnings season is kicking into gear and expectations are for a generally healthy set of financial reports.
Analyst forecasts point towards growth of 15-20 per cent for the market as a whole, compared with first-quarter earnings in 2003.
Such an outcome should be positive for the US stock market, although some commentators worry that most of the good earnings news may already be reflected in current share prices. Despite the rapid pace of growth in corporate profits, US shares still look expensive in terms of price-earnings ratios and dividend yields.
However, those with a more optimistic disposition take the view that strong earnings reports are likely to be reflected in higher share prices.
Reasons for such optimism include ongoing healthy growth in the US economy and the maintenance of exceptionally low short-term interest rates for a further considerable period of time.
The table shows official interest rates and 10-year bond yields for the major economic blocs and it highlights just how low current global interest rates are.
Short-term rates vary from the zero Overnight Call rate in Japan to the 4 per cent Repo rate in the UK. The European Central Bank's (ECB's) 2 per cent Repo rate is in the middle of this range, while the 1 per cent US Fed Funds rate is at the lower end of the range.
This low interest rate regime has now been a feature of the financial landscape for a prolonged period. The prize for longevity goes to the Japanese central bank, which has maintained a zero official interest rate since March 2001.
The US Federal Reserve and the ECB last altered their official rates in June of last year.
Only the Bank of England has recently begun to alter its stance on interest rates, raising its Repo rate by 0.25 per cent to 4 per cent as recently as February.
Any change to the current policy stance adopted by monetary authorities will have a major bearing on the prices of equities and bonds.
With the exception of the Bank of England, the monetary stance adopted by central banks is clearly expansionary. Therefore, these monetary policies should be acting to support economic growth and to underpin price levels in asset markets.
The strength of this monetary stimulus can be assessed with reference to the level of real interest rates (i.e. adjusted for inflation), and the spread between long-term bond yields and short-term interest rates.
The current rates of inflation in the US and Europe range from 1-2 per cent and, as such, real interest rates are roughly zero in Europe and marginally negative in the US. In Japan, prices have actually been falling in recent periods so that the zero nominal interest rate translates into a slightly positive real rate of interest.
Overall, we can see that, with the exception of the UK, global real short-term interest rates are broadly zero.
Historically, short-term real interest rates have typically been in a 2-3 per cent range so that it is apparent that current real rates are well below the historical norm.
Another way of assessing the stance of monetary policy is to compare long-term bond yields with short-term interest rates.
At the moment, 10-year yields on government bonds are much higher than short-term rates. The yield on the US 10-year bond is 4.23 per cent, while in the euro zone, the 10-year German Bund is yielding 4.07 per cent and the yield on the equivalent UK gilt is a little higher at 4.88 per cent.
This suggests that bond investors are assuming that short-term interest rates are likely to rise by a significant margin over the medium term. The only exception is Japan, where the 10-year yield remains at a lowly 1.53 per cent.
Rising interest rates are generally viewed as likely to exert a negative influence on stock prices. Higher rates may entice more investors to leave money on deposit, while higher borrowing costs will put pressure on the profits of those companies with high levels of gearing.
However, if rising interest rates occur because of strong economic growth, then any negative impact on stock markets could well be outweighed by the beneficial effects of better economic growth.
In the current environment, interest rates are only likely to rise if policymakers take the view that economic growth is on a sustained upward trend. In this regard the jury is still out.
In the US, the Federal Reserve has been prepared to keep interest rates at 1 per cent in order to copperfasten the economic recovery. In Europe, there is a possibility that the ECB may lower interest rates if the euro-zone economy fails to improve considerably in the second half of this year.
For investors in equities, there seems to be little to fear with respect to official interest rate policy for the foreseeable future.
If the global economy falters, some central banks, primarily the ECB, still have the scope to lower rates further, while the US Federal Reserve would keep rates down for a prolonged period.
If growth moves on to a more sustained and faster trajectory, central banks will raise rates once they are confident about the durability of faster economic growth. In this scenario, the boost to corporate profits from faster growth would easily outweigh the negative influence of higher rates.
