Corporate investment and low borrowing costs bode well for economic recovery in America. Meanwhile, investors can find bargains in equity markets as valuations remain low.
Fiscal austerity is another cause for anxiety. While events in Europe have highlighted the problems caused by a change in the economic/financial backdrop, there are equally those who are concerned that reducing government spending when the recovery is so fragile will prompt a return to recession. This uncertainty also undermines economic sentiment. The Investors Intelligence survey showed that as of mid July there were more investors expressing a bearish view than a bullish outlook for the first time since May 2009.
Despite these woes, there are some grounds for optimism.
- Equity valuations are cheap. The 2.6% dividend yield on the Datastream World equity index has only been higher 11% of the time in the past 25 years (based on weekly data). Furthermore, in the last cycle it was only in June 2008 when the dividend yield rose above this level. While these are not the rock bottom valuations experienced in the 1970s, this is different from the situation in Japan when valuations remained high through the 1990s.
- Policymakers recognise the downside risks, and importantly have the experience of the situation in Japan to draw on. This does not mean that policy errors cannot occur, but does make it more likely that a different mistake is made rather than a repetition of the deflationary episode in Japan. In this regard, the steep American yield curve and negative real interest rates stand out as being different from the policies pursued in Japan.
- Market interest rates are not reacting as they did in 2008. It is not just homeowners that are experiencing low borrowing costs. While corporate bond yield spreads over Treasuries are wide, this is largely a function of unusually low Treasury yields. In absolute terms corporate bond yields are near the lowest levels from 2003-04. Furthermore, in the developing world many are able to access financing at the lowest ever cost.
- Investor concerns that the world faces a synchronised downturn as debt deflation overwhelms the developed world, while problems associated with an overheated economy sink the developing world, may not be realistic. Slower growth in the developed world should allow greater scope for non-inflationary growth in the developing world, as the world experiences the reversal of conditions from the late 1990s to 2000. Equally, were there to be a bust in the developing world, this would encourage further policy stimulus in the developed world among policy makers keen to avoid a deflationary cycle.
- The drop in American employment exceeds the decline in output, implying that businesses are operating more efficiently. This has contributed to a rebound in profit margins. As capacity use rises, this encourages business investment. Historically it has been the direction of change in operating rates that has determined trends in business capital investment.
A low level of capacity utilisation has not prevented corporates from increasing their rate of investment. The rise in tech investment in America since the second quarter of 2009 is an encouraging indication that this cycle will not prove to be different.
Is it possible that as companies are encouraged to make use of the cash piles that were built as protection against the illiquid credit environment in 2008-09, despite all the fears of a vicious downward spiral, a virtuous cycle develops where rising business spend further raises capacity utilisation and income levels?