Global markets have been unusually weak recently. US 10-year Treasury bond yields have moved up through the 3% level, breaking a 30-year downward trend and provoking a circa 7% drop in the FTSE 100 index over the first few days of October. Bond yields are important to markets because they are used to discount the future value of cash flows from investments. All else being equal, higher bond yields or discount rates lower the present value of future cash flows used to value assets.
Higher discount rates are particularly painful for equities that are set to provide returns far into the future. Arguably, the most sensitive assets in the market are fast-growing US tech stocks. These have led the market up in recent years but generally lack a dividend and sit on expensive valuations that rely on widespread confidence in their future growth. This makes them particularly vulnerable to higher discount rates and it is no surprise that such companies have led the market down in recent days.
If we put things in context, market volatility over the last 12 months follows a period of strong gains. As things stand, global GDP growth has slowed a little from its recent peak but still holds at a robust 4% year-on-year. Despite the odd hiccup, one could argue that global growth should continue to rise over the long term through rising populations, continuing innovation and productivity improvements. In turn, equity markets are the ultimate beneficiaries of this growth.
In the meantime, it is important to remember that volatility is not all bad for long term investors. In particular, it offers the opportunity to take advantage of unusual price swings. The key to long term equity investment remains the ability to stay invested during times of stress.