The warning signs continue to mount in the world’s stock markets.
It’s a nervous time for investors.
Interest rates are rising in the US.
But elsewhere interest rates are falling.
And regardless of where you look, stock prices are falling too.
What’s an investor to make of it?
Today, we’ll try to help you understand what’s happening, and how you can play it…
Last week the US Federal Reserve raised interest rates.
It was the first interest rate rise since 2006.
And it came after the Fed had kept interest rates near zero for seven years.
The Fed kept interest rates low in an effort to stimulate the economy. It was part of the multi-trillion dollar money printing programs.
But did it work? On the surface it did. But deeper down, the evidence is that low interest rates have caused more problems than they have solved.
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Public and private debt keeps rising
US government debt was already rising before the financial meltdown in 2008.
That’s part of why the meltdown happened.
But since then, US government debt has really taken off. You can see from the white line on the chart below that it has doubled since 2008.
But look at the yellow line. This is private sector debt, excluding mortgages. It includes credit card debt, car loans and other items.
As you can see, after dipping from 2008 to 2010, these debts have climbed 50% since 2010:
Consumer debt now far exceeds where it was at the peak of the financial meltdown in 2008.
Those are just two of the warning signs that the market could be at a key inflection point. By that, we mean the market could be on the verge of taking a big tumble.
That’s what makes last week’s interest rate rise by the Fed all the more risky. Not that we believe interest rates should stay low, but rather that we believe the market has underestimated the impact of higher interest rates.
Or should we say, the market had underestimated the impact of higher interest rates. Friday’s action on Wall Street perhaps suggests that attitude is changing.
Look forward to more of the same in 2016
Just two days after the rate rise, the ‘excitement’ of higher interest rates appears to have worn off.
On Friday night, the Dow Jones Industrial Average fell 367 points. That’s a drop of 2.1%. The S&P 500 index fell 36 points, or 1.8%.
It means those indices are down 3.9% and 2.6% respectively for the year. And if higher interest rates begin to have an impact on company profitability, stock prices could fall much further.
Remember how we’ve pointed out the rising interest rates in the ‘junk bond’ market. Junk bonds are high risk bonds where the issuing company has a higher chance of defaulting on repayment.
But it’s not just junk bond yields that are going up. The yield on higher quality bonds has risen this year too.
At the beginning of this year, the iShares iBoxx Investment Grade Corporate Bond ETF [NYSE:LQD] yielded less than 3.3%. Today, it’s yielding just under 3.5%.
That may not seem like such a big deal. But remember that companies are in much more debt today than they were seven years ago. If the trend in interest rates goes higher, it could start to push some companies over the edge.
We’re specifically thinking about energy companies, which are taking a double whammy hit. Not only are their debt costs rising, but the oil price continues to plummet.
There’s a real danger that most investors and commentators have underestimated this. It’s why we’ve encouraged investors to have a cautious approach to the market.
It has been the right move. So far this year, the S&P/ASX 200 index is down 5.4%. Even factoring in dividends, Aussie stocks are down 1.3%.
In short, interest rates will play a big part in where the market goes next. As much as we’d prefer to focus on just investing in good companies, we can’t ignore the actions of the central banks, or the clues the bond market is giving you about the fragility of the financial system.
It looks as though 2016 is setting up to be just as volatile a year as any since 2008.
Ed Note: This article originally appeared in Money Morning.