In emerging markets, economic growth is under pressure as central banks tighten monetary conditions. But elsewhere, news has turned rosier.
In Europe, recent data show an uptick in growth in the core hotspots and a stabilisation in the peripheral areas. In the US, the jobless rate is heading down and the fiscal deficit apparently evaporating in the face of spending cuts and better than previously expected economic momentum. In Japan, Prime Minister Abe’s monstrous fiscal and QE splurge is now being allied to attempts at structural reform.
Even in the UK, revisions to previously reported numbers now mean that there wasn’t even a second dip into recession, let alone the third that the press became so excited about in the spring.
Combine this with loads of QE (money printing) in Japan and the US, a previous large programme in the UK and endless efforts by the European Central Bank to achieve the same end without actually “doing it”, and it becomes apparent why equities have done, and continue to do so well. After the brief pull-back in late May and early June, leading developed world equity indices are now back to – or past – all time highs in capital terms, let alone with dividends added back in.
To put this into perspective, the S&P 500 index in the US is now up by 37% in total return terms since the end of 2011. You can scarcely see the June correction on the chart:
On the other hand, fixed income has been suffering; ten year government bond yields in the US and the UK are back above where they were in late June, and the consensus trade is now to be in risky equities, “because government bonds are risky too”. The UK Gilts All-Stocks index is down by 0.7% from the end of 2011, and 6% from the end of May.
The trouble with this picture is that once all that lovely economic growth comes through, once companies start to invest and hire and unemployment falls, then central banks are going to have to start removing the precious oxygen of liquidity.
And then the questions start coming in: can sexy, scantily-clad equities continue to climb without that oxygen? Can companies sustain their very high margins whilst they invest? Are current valuations such a support without ultra-low interest rates?
The fixed income market is focused on this conundrum; the equity market is not.
Eating at the trough of risk these days is getting to be a dangerous game for your teeth. The way central banks are adding cash to the system is like pulling on a very long elastic band with a brick tied on the end. At some point – maybe not now, and maybe not even tomorrow – that elastic is going to get so tight that finally it moves the brick. Violently. Let’s hope it doesn’t come zooming back and hit us all in our greedy mouths stuffed full of equity cake.
Richard Champion is chief investment officer at Sanlam Private Investments