ENP Newswire - 24 January 2014 Release date- 23012014 - The last five years have been shaped by the most accommodative monetary policy ever implemented by central banks in Europe , the US and Japan . The zero interest rate policy and the gigantic interventions in the bond markets make this phase the greatest monetary policy experiment in modern economic history. Our industry has been dealing for months with the question of when the US central bank will start to gradually normalize monetary policy. In May and June last year, this subject triggered substantial unrest in the financial markets and upheaval in many investment categories, which showed investors just how dependent the markets were on monetary stimulation measures. Interestingly, the most directly affected US stock market reacted very favorably. 'Though a claim to the contrary is often made, there is no lack of investment alternatives. Some of them are currently simply unattractive.' Alex Borer , Head Asset Allocation Strategies The medium-term positioning of our portfolio is also affected by the assessment of future monetary policy. The impact of the central bank's communication of its goals on the development of macroeconomic data, the change in investors' expectations, and the price reaction on the markets generates plenty of analytical and price-relevant dynamite - at least in the short to medium term. Over the long run, however, the short-term reactions of market participants are not important; the key factor is the development of the fundamental data. Bond yields have been falling dramatically since 1981. For example, yields on long-term US government bonds have declined from 15% to less than 3% since then. This development was facilitated by the structural decline in inflation rates and constantly overestimated inflation expectations. A turnaround in bond yields in the not too distant future is inevitable. The crucial question for the stock markets is how strongly stocks will suffer from a normalization of monetary policy with bond yields possibly rising. In this regard, there are three factors relevant: the discount effect, the impact on company profits, and portfolio rotation by investors. The share price of a company represents the present value of all expected profits. If the interest rate at which future profits are discounted rises, the present discounted value falls, as does the share price. A great number of investment possibilities is always available to investors. Though a claim to the contrary is often made, there is no lack of investment alternatives. Some of them are currently simply unattractive. Therefore valuations of individual asset classes are always to be looked at in a relative light. Let's compare the valuations of equities with bonds - again, the United States will be used as an example due to the long time series and the relevance of the markets. Despite a very good performance in 2013, US equities still offer an above-average risk premium (earnings yield minus bond yield). If equity valuations, as measured by the risk premium, rise to the average value of the past 50 years, bond yields can still rise about three percentage points to justify current prices. Equities are therefore well protected against the discount effect, which usually weighs on share prices. Rising bond yields cause corporate borrowing costs to increase. One good effect of the financial crisis was that companies organized their balance sheets considerably more defensively and sharply reduced their net debt. A three-percentage-point rise in bond yields would reduce corporate earnings by only around 12%, according to model calculations. Finally, the yield at which investors begin to rotate out of equities and into money market investments or bonds needs to be assessed. First of all, it must be made clear that a paring back of central bank bond purchases does not mean that policy rates will be raised. Higher interest rates will come much later. The question then becomes: What is the interest rate at which money market investments become attractive? I argue that investors do not consider money markets as an investment possibility until a level of 3% is reached. In addition, there has not been a major rotation from bonds into equities despite record-low yields. Also in 2013, bond funds saw client money flowing in, as has been the case in every year since the financial crisis began in 2008. Moreover, the inflows to equity funds were not alarmingly high. The shift into equities has therefore not begun. The inverse conclusion is that it will clearly take higher bond yields in order to make investors enthusiastic. Thus, the rotation effect does not currently pose any great risk for the stock market. What does this mean for you as an investor? This simplified exercise was intended to show that the normalization of monetary policy does not compromise the long-term appeal of the stock market. Equities remain strategically attractive and belong in a diversified portfolio. Download LGT Investorama The LGT Investorama we can only show you depending on your country of domicile. To download this document onfrom our webpage 'Market information' please go to 'Domicile selection' first: LGT market information
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