Posted by:
Andrew Bell

6 July 2010

Most global equity markets have given back between one third and a half of the gains made since markets troughed in early 2009. So, this has marked significantly more than a mere pothole on the road to recovery, leading some to question the fundamental basis for the bounce in equities and to express concern that negative wealth effects from falling equity values could contribute to falling demand and confidence (on the part of companies and individuals).

The cycle of falling asset values, weak confidence, lower demand, reduced creditworthiness, an erosion of confidence in bank balance sheets and a squeeze on credit (feeding further weakness in asset values) was initially arrested in early 2009 by concerted official intervention. However, like some malign form of economic Nosferatu, this fear-fuelled progenitor of economic anaemia has taken wing again in recent months, as solvency concerns centring on the “Un-Med” economies of Europe have sucked liquidity away from the credit markets. European banks that have significant exposure to the government bonds of countries whose ability to repay has been questioned have found it hard to borrow short-term money, other than via the European Central Bank.

In addition to this, the authorities have moved from undiluted growth stimulating policies in early 2009, when the fear was of a slump into an economic depression, to a more heterogeneous policy stance. Some governments and central banks are evaluating when and how fast they can reverse their stimulative policies and return interest rates and budget deficits to normal settings. As a result, investors have moved on from relief that economies are still alive to worrying about the debilitating effects of the debt overhang and the risk that the economic paramedics are withdrawing care before the patient has been stabilised. As a result, a timely bout of consolidation from equity markets that had rallied strongly until April has begun to look like a renewed flirtation with the death spiral that enveloped financial markets 18 months ago.

Of course, the reason that equities and corporate bonds rallied after March 2009 was they had priced in the risk of depression, just before it became clear that policy stimulus was restoring the world’s economic pulse. Economic growth upgrades followed and financial markets performed their function in directing savings to companies that needed to strengthen their balance sheets (and were able to make their case, in a world of more stringent capital rationing). Company earnings have been better than expected so, after the dividend cuts in 2009, earnings and dividend support for equities has moved in to colonise the territory marked “hope” on the map of the markets’ progress from the 2009 lows.

Given that equity valuations have been supported by earnings and early signs of resumed growth in dividends (BP being a notable, but special, exception) should we be pleased at the buying opportunity thrown up by lower equity prices or alarmed at the implied warning from waning investor confidence and the stock market’s status as a leading indicator?

On economic growth, consensus forecasts for 2010 have been steady at slightly above 1% for Europe and the UK and a more robust 3% for the US. 2011 numbers forecast an improvement to over 2% for the UK, with the US (3%) and Europe (1.5%) growing at similar or better rates than in 2010. There may be some lag between the volatile conditions since April and changes in forecasts but even if estimates weaken from here we are some way from the renewed recession feared by bearish commentators. Indeed, in some regions such as Europe and the UK, currency weakness is a significant support for growth and corporate earnings, in markets that have a global growth exposure rather than a purely local one. Business surveys, which are fairly timely measures of confidence, have held up or, where they have corrected, remain well above the level marking the border between economic growth and shrinkage. Furthermore, the recent scare over sovereign (or half sovereign) credit ratings, leading to pressure for faster fiscal tightening, is likely to shift the priority of monetary policy setters towards safeguarding recovery, rather than any strategy to exit their stimulus policy. Chinese tightening measures, now showing up in an (intended) slowing of growth are likely to adopt a change of course, should the slowdown go too far. The US is less eager than European zealots to tighten budget policy, procrastination happily coinciding with the recognition that coordinated demand reduction resulting from attempts to reduce budget deficits will have to be carefully managed if it is not to prove self-defeating.

On the available evidence equity and bond markets appear to be discounting an economic outlook that is significantly worse than market forecasts. Equity prices are usually more volatile than earnings and have fallen this year against a backdrop of rising estimates. Government bond yields of 3-3½% reflect a myopic “flight to quality” – flawed because if renewed recession produces deflation (necessary for such low yields to be attractive) it would destroy issuers’ fiscal arithmetic leading to credit downgrades, undermining the case for bonds by raising doubts over their repayment. Ultimately, if a measured management of the current deleverage cycle proves impossible then aggressively inflationary policies are likely to be adopted, undercutting the valuation via inflation. Treasuries and gilts therefore look unattractive if there is a recovery (as it would lead to reduced risk aversion and/or higher inflation) and potentially disastrous if there is not (as this would lead to default or much higher inflation). The only solace is if there is a period while policy makers try to shore up their fiscal position, before it is clear either that recovery has resumed or a way needs to be found out of renewed recession. This feels like picking up pennies in front of steamrollers.

Equities too would be unwanted if recession took hold again but would ultimately participate in a general inflation, albeit with an uncomfortable transition. This is probably one of those occasions when equities markets have given a “false positive” result in predicting recession. In what seems to be the likelier event of continued, though inconsistent, economic recovery equities appear attractively priced, with (growing) dividend yields close to or above government bond yields and earnings yields of 7-10%. There may be greater concentration on quality than in the first flush of the market’s bounce last year, however. Depending on whether recovery or recession is the story for 2011, equity markets could easily be 20% higher or lower by next year, with more evidence supporting a guardedly optimistic outlook than an extrapolation of the recent gloomy mood.

Comments or feedback are always welcome at theblog@witan.co.uk.

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