Posted by:
Andrew Bell

16 August 2010

In the past 9 months, equity and bond markets have performed almost as many jinks and turns as a gazelle being chased by a cheetah. A year-end rally was followed by New Year introspection. An earnings-driven recovery followed, succeeded by a mini-crash driven by fears about the health of the Club Med members of the €uro. A further results driven recovery in July has given way to renewed fears that growth is faltering. Each of these phases has been associated with strong index movements and apparently firm conviction by the market “consensus” yet the overall impression from this tergiversation is of a total lack of confidence in the direction of the economy and how to price it.

This pattern ought to be enough to remind us that we need to make our own minds up about the fundamentals, what is cheap and expensive and what suits our own attitude to risk. Momentum is a treacherous guide at market tops as well as troughs. 

Part of the confusion is because it is not clear whether low interest rates are part of the cure for the debt overhang from the last credit cycle or a symptom of continued malaise. Clearly, it is better to have low interest rates than high ones if the abiding problem of the economy is that too much money has been borrowed by people who cannot easily pay it back. That keeps alive the possibility that the debt will be reduced by repayment rather than default, even if expected returns for the lender/long suffering depositor prove disappointing. So, low interest rates appear to be a sensible form of medicine for convalescent borrowers but they have not yet fired up the credit engine that usually helps to spur economic recovery after recessions.

Both borrowers and lenders appear hesitant about new loans. The severity of the credit crunch and debt hangover has created a wish to reduce borrowings (one reason why the banks are finding it hard to meet lending “targets”). The other feature of the credit crunch, of which echoes still linger, is that the willingness to lend has been compromised by doubts over borrowers’ creditworthiness. At its worst in 2008, banks were unwilling to lend even to each other overnight, such were their concerns about the stability of the financial system. Although the interbank market is working again, the banks remain more dependent than they would wish on wholesale credit markets and face the need over the next few years to refinance the emergency aid provided by governments.  This acts as a further brake on lending activity, adding to the likely rationing of credit.

Government debt markets do not appear fundamentally healthy, despite some countries’ bonds performing strongly. US, UK and German government bonds trading close to or below 3% appear to be a sign of unease at the sustainability of the economic recovery that started in 2009 rather than of confidence in the value of the yields offered by such borrowers.  Furthermore, some government bonds are seen as unsafe, so money is being reallocated from them to the “safe” credits. There is an overlay of nervousness at the consequences if one or other OECD government were to default on its bonds, owing to the financial sector’s widespread exposure to such bonds. Financial markets have traditionally looked to government bonds as the bottom rung of the risk ladder, on which the valuations of other assets are built. If doubts exist over the riskiness of the risk free rate, volatility in other assets is bound to follow.

If the credit system and the banks are fragile, it would take little to erode confidence, turning weak credit growth into a renewed crunch. If some governments’ finances are tricky, higher interest rates could make them impossible and force a default. The ability of economies to function depends crucially on confidence about the future.

With this in mind, it seems wise for governments to reduce the electoral cycle temptation to criticise the corporate sector rather than encouraging it to lend, invest, increase hiring, make profits and pay dividends. Cyclical and political pressures have engendered a defensive mindset whereby companies try to diet themselves into good health in ways that tend to curtail economic growth. If companies are to expand, they need assurance about the future rules. Australia has recently retreated from a retrospective tax hike on its resources sector but the political debate in the US remains unusually hostile to business. By contrast, the UK has sent out a signal that the corporate tax rate will be reduced to amongst the lowest in the developed world which, if combined with a continued competitive level of sterling (unlike the 1980s and the 1990s when the pound surged) will materially help with the rebalancing of the UK economy.

Another characteristic of market behaviour in recent months has been repeated drinking at the same waterhole of disappointing news. Although the underlying problems for the world economy are significant, they are not startling revelations. The prospects for a (more or less) orderly workout appear greater than a year or two ago. Government bond markets offer less compensation for inflation than at the start of the year. Although near term prospects for inflation may have reduced as people reassess the headwinds to a normal recovery, this is of limited value when buying a 10 (or more) year bond. Low interest rates for a sustained period may underpin government bonds (since a 10 year bond is the sum of expected interest returns over its life and these expectations are reducing). However, base rates are below inflation so sustaining them there does not guarantee a good return for bond holders.

Equities have seen a profit recovery that does not yet show signs of peaking. The underlying earnings yield of 8-10% on many equities (with dividend yields above the yields on government bonds) appears to price in a significant risk of mediocre growth. Clearly, an outright recession would undermine current earnings forecasts so a critical assessment needs to be made about whether the evidence suggests a “double dip recession” or whether markets are overreacting to disappointment over the pace of growth, despite already expecting it to be weak. The path of sentiment is hard to predict and has an overlay of determined pessimism at present. Nonetheless, equities appear priced to deliver real returns to investors whereas government bonds and cash deposits do not (although there may be other, sleep-at-night related reasons for holding them).

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

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