Following the Swiss National Bank’s surprise decision to remove the franc currency floor in January, most of the major markets settled into an eerie quiet through much of the first half of the year, despite the ongoing calamity in Greece.
Warning signs showed in June as the first cracks appeared in the Chinese stockmarket bubble. Yet, developed market stockmarkets only began to stir once the People’s Bank of China devalued the renminbi on 11 August. In the final two weeks of August, equity markets erupted in some extremely violent moves that were disturbingly reminiscent of 2008. Daily fluctuations of up to 5 per cent became the norm. The Vix index leapt from 15 to 53 within three days, leaving many options prices too volatile to quote. This proved unsettling even for hardened market veterans.
It is not easy to understand why markets have reacted this way. Was this merely a technical situation caused by computer traders while the human ones basked on the beaches? Or are markets presaging a serious downturn in the global economy?
Despite the alarm caused by the speed of the correction, the magnitude of the fall is well within historical norms. The drawdown on the FTSE All Share index was 13 per cent, a not uncommon event over recent years.
Equity valuations may be high and the ongoing economic outlook may remain fragile but we do not believe that this is the start of a bear market. The credit crisis brought the credit super cycle, which had started in the early 1980s, to an abrupt end. No longer will economies enjoy super charged growth created by spending and brought forward through borrowing.
Future growth can only be generated by productivity enhancements, and where it exists, population growth. Western nations have accumulated colossal debts that will take years to repay. Fortunately, many of these have been transferred from the private to the public sector: only governments have the necessary time horizons to address these debt mountains.
Despite the breadth and size of monetary interventions, the deflationary trends in the economy remain strong. The collapse in the oil price over the past 12 months only adds to the intensity of the pressure on prices. Continued deflation could crimp margins.
Returns on equity in the US are at elevated levels and these have begun to dip over recent months as profits from energy production plunge. We have seen the damage that deflation has brought to supermarkets in the UK but what will be next? We sense that companies with high leverage ratios may be particularly vulnerable. Debt costs can only go one way from here and growth will be hard to find. Margin pressure on a geared business can be catastrophic.
Modern economies are dominated by service-based businesses that have limited capital requirements. China has sucked in excess capital to finance its breakneck expansion. With its roads and factories now largely complete, and with growth rates declining, the nation’s hunger for capital has waned as it too builds up its service sector.
Yet, there has been no corresponding diminishment in the demand for equities. If anything, demand for equities may have increased as the pain suffered in 2008 is forgotten. Greedy eyes study the returns generated by equities and blanch at the paucity of what is on offer in fixed income markets.
The supply of equity is low, returns on equity are elevated and borrowing costs are cheap. Marginal buying could propel equity markets significantly higher from where they are now. The gulf between the cost of capital and the return on capital has rarely been greater. Competitive pressures are forcing corporate tax rates lower around the world and shareholders will be the beneficiaries. This can only stretch the mismatch between the haves and the have-nots.
For those brought up in the 1960s and 1970s, the political pressure to address this imbalance appears absurdly light; superannuated socialists are being met with derision. Crime rates have fallen and living standards for the majority are acceptable. This may not be the land of milk and honey but food is in the kitchen and 50 inch TVs are in the lounge. The status quo will persist.