Central banks in the spotlight

The glass remains half full for stock market investors this week despite a growing list of concerns. The MSCI World index is less than 2% off its August peak, despite, not because of the economic, political and financial headlines.

Top of the list is the rising cost of capital as bond yields head towards the 5% danger zone. With oil above $100 a barrel, growing concerns about the impact of AI, and a hiking cycle for the world’s central banks looking imminent, markets are climbing a steep wall of worry.

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Fed in focus

Central bank interest rate decisions are in the spotlight this week, with the Fed’s announcement on Wednesday looking like a defining moment in the relationship between Donald Trump and new Fed chair, Kevin Warsh.

Trump nominated Warsh after berating his predecessor, Jay Powell, for keeping interest rates higher than the President thought they should be. Warsh is new in the job, but so far he has shown no inclination to fall in with the White House’s agenda. He is determined to preserve the Fed’s independence and its credibility in the markets.

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After hawkish comments from Warsh at the recent Jackson Hole summit, and following higher than expected inflation and stronger than expected jobs data, a quarter point hike looks more likely than not this week.

The Fed is not the only central bank in focus this week. The Bank of England and Bank of Japan announce rates on Thursday and Friday respectively.

Here, the Bank of England is expected to hold for one more time in the run up to next month’s important first Budget of the Burnham era. But it could be a short reprieve. Four hikes are pencilled in for the next 12 months as inflation remains above target and recent economic data has been stronger than expected.

Meanwhile, the Bank of Japan is widely forecast to succumb to pressure from the US to raise rates to support the weak yen. With interest rates at just 1%, cheap borrowing costs in Japan are seen as one reason for the Japanese currency’s historic weakness.

Rising cost of capital

Rising interest rates and bond yields, not just in America but the world over, are one of the biggest threats to the ongoing equity bull market.

With the pendulum swinging from hopes for interest rate cuts to a new tightening cycle, bond yields are pushing into what many see as a danger zone in which higher borrowing costs become a drag on corporate profits, reduce the present-day value of future earnings, raise the cost of funding governments, and start to offer investors a compelling alternative to more volatile shares.

This is a new regime for investors after a decade and a half of near zero interest rates and bond yields.

The optimistic view is that still robust earnings growth will continue to keep valuations in check and support the ongoing bull market. Profits are forecast to continue growing at about 20% a year. That in turn has dragged the average price-earnings ratio 16% below its recent peak.

With less pressure on valuations, it may be that the new regime will usher in a rotation and not a correction. Investors may shift their focus from growth to value, from the US to other markets, from large cap stocks to small and medium sized companies, and within hot sectors like AI from recent winners in semiconductors to the companies that will benefit from the new technology but which are not yet burdened by high expectations.

This is the optimistic view. The more pessimistic take is that most bull markets over the years have been ended by a rising cost of capital. Higher borrowing costs tend to be the straw that breaks the camel’s back in investment.

Which of these views prevails is the big question as we enter the traditionally difficult autumn period in the markets.

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• Read: 7 reasons to stick with shares
• Read: Why the rising cost of capital matters for investors
• Read: The hidden 60% tax rate – and how to avoid it

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Overseas investments will be affected by movements in currency exchange rates. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.