Current low interest rates and the way they behave remains an important aspect of the current economic situation.
One industry view compares the current situation in most western economies to that of Japan 20 years ago. Interest rates in Japan have been frozen near zero for nearly two decades.
This low economic growth, low return scenario is one that our model must consider. Balanced against that scenario is the fact that inflation measures are looking quite high.
This raises the spectre of a situation where easy money and weak growth produces an economy which is highly in debt and hence vulnerable to shocks in the market.
This could result in a British version of the current Spanish situation where government debt becomes hard to service and interest rates rise sharply but with an additional British twist of high inflation.
Neither of these scenarios would be good for any type of asset return.
Even a return to growth would have a mixed effect in the short to medium term. Interest rates would rise, resulting in corresponding losses on bonds and reducing equity returns over the medium term. This is because, in general, bond prices move in an opposite way to interest rates so that when interest rates rise, bond prices fall and vice versa.
If an investor buys a bond and interest rates turn out to be exactly as expected then the return obtained from the bond is completely predictable.
In order to get back more than expected from a bond, interest rates must turn out to be lower than expected.
If interest rates are lower than expected, then this will result in lower future returns on fixed income investments. This is because when new bonds are offered they are typically issued at or close to the prevailing market interest rate.
High returns in fixed income investments come at the expense of future returns. In addition, rising interest rates generally affect equity returns inversely.
Although the effect of interest rates does not have an immediate impact on the stock market, the cost of borrowing money has an influence on the cost of doing business for many companies. The expectation of any changes in the future growth and future cash flows of a company is a primary driving force in determining the appeal of equities.
The potential returns on assets under all three of the scenarios described above do not appear to be particularly strong, suggesting that it will take time for investment prospects to improve.
Bruce Moss is founder of eValue, a provider of financial forecasting and risk-assessment tools
