Great expectations or just a rally?

Global equity markets have rallied significantly since early March. The FTSE 100 is 23% higher and American equities are up 35%. So is this the start of a new bull market or is this just another bear market rally with more turmoil to come for equity investors?

There are fundamental reasons why equities have rallied over the past few months. Since the financial and economic turmoil began in mid-2007, equity markets have rallied off the back of changes in sentiment and risk appetite, and news flow surrounding the financial sector. However, this time around there has been an improvement in underlying macro fundamentals, which has led equity prices higher in anticipation of a turn in the global economic cycle.

Equity markets are driven primarily by expectations. Over the past two years, both economic and profits expectations have been revised down dramatically. For example at the beginning of this year, consensus expected just a 5% fall in profits growth for British companies in 2009, consensus now expects a 32% fall. In the earlier part of the year this downgrade to expectations drove equity prices lower and meant continued uncertainty as to how to value equities and when to start to price in a rise in profits driven by an improvement in underlying economic growth.

Equity markets tend to move higher about six months before the economy starts to recover. There is a general expectation that economic growth will start to improve towards the end of this year and therefore a rise in equity prices since early March does make sense. There have been a number of key economic indicators which have suggested the green shoots of economic recovery. We would focus on a select number of indicators.

A major global inventory cycle is behind the recent improvement in economic data. As demand collapsed last year, firms were initially slow to react and stocks of unsold goods increased. Companies then responded by cutting production in excess of the fall in demand. This has led to an aggressive inventory liquidation in the first quarter of this year. With inventories now becoming better aligned with the level of sales, firms have started to resume production. Global trade has stabilised and business surveys have begun to improve. As the inventory cycle turns, it should mean that fewer jobs need to be shed.

The American housing market is critical for a sustained global economic recovery. American housing problems were at the epicentre of the credit crisis, taking us into the current economic downturn and they will be a contributor to pulling us out. The American housing market is beginning to show signs of improvement as the months of supply of unsold homes data has started to fall and we expect American house prices to start to stabilise towards the end of this year. This is important for the banks because if asset prices start to stabilise, losses can be quantified and investors and the financial sector can start to take a view on the future.

Credit conditions are also incredibly important. If consumers and companies cannot borrow, the economic recovery will be hindered. The US Senior Loan Officers Survey gives a good indication of how tight credit conditions are and this survey has started to reflect an easing of credit conditions in the past couple of months.

As mentioned above, over the past two years expectations have been downgraded significantly. However, in the past few months, as economic indicators have started to suggest signs of economic recovery, economic and profits expectations have grad­ually started to be revised upwards, which has suppor­ted equity prices. For equity prices to continue on an upward trajectory, economic growth needs to pick up and stabilise for profits to start to meaningfully recover.

Unfortunately, this is where the risk for equities now lies. Our own economic forecasts suggest the global economy will start to recover towards the end of this year – which is a positive for equities near-term and supports
5-10% upside for British equities. However, when it does occur the eventual economic recovery will be gradual and economic growth will remain below trend at least during 2010, which will be a drag on future profits growth. The risk now is that after a long period of downgrades to expectations, market participants may upgrade their expectations for growth too quickly and therefore face another round of disappointment as demand remains weak for a prolonged period of time.

As the market continually re-prices the risks surrounding the strength of the cyclical recovery, equity markets will continue to be volatile leading to some weakness later on this year. Changing assumptions for the equity risk premium, profits growth and long-term potential growth gives a different conclusion as to where equity markets should be trading. More evidence is needed that the economic green shoots discussed above are improving enough to drive a sustainable recovery in economic growth and ultimately equity markets.