Equity markets are producing supra-normal returns. To March 18th, the portfolio is up over 15% year-to-date, over 100 basispoints ahead of the index. Many investors would be happy with such a gain over a full year rather than a mere twelve weeks, so are puzzled, the more so as respected pundits agree that the data makes for easy stories of rampant inflation, collapsing government credit and a prolonged global recession. Equity markets, however, are stubbornly refusing to follow the script. Their strength breaks the normal rules: no major market is obviously cheap on an historic basis, be it CAPE (cyclically adjusted PE ratios), Tobin's Q (a measure of replacement cost) or consensus growth in earnings. The economic background does not suggest a robust upturn in corporate profits or GDP growth. Yet high valuations and further gains are likely to be normal for several years. During much of the 1990s it was believed that a nirvana of steadily rising economic activity and market returns had been achieved, known as “the Goldilocks scenario” because the pace was neither too hot nor too cold. Today this applies to equity markets, subject to four conditions.
Economic activity must remain sluggish. Central banks are fine-tuning economic activity even more than the old USSR. Yet provided economic activity merely splutters along, the giant money printing experiments will continue, such as the Federal Reserve Bank's monthly $85bn asset support programme, equivalent to 6.5% of annual GDP. Proportionately even larger measures havebeen taken by the UK. The European Central Bank too is wedded to money printing (“do whatever it takes”) to support member states and the Eurozone's banking system. Japan's new government and the Bank of Japan's even newer governor want to replace previous caution with aggressive money printing, devaluation and pro-inflation stimuli. However, if economic activity does recover strongly, these support programmes will be reduced; central banks will neutralise their previous expansion, thus removing a key support for equity prices.
Another threat to Goldilocks markets is political - that governments actually follow up their rhetoric on structural budget deficits and government debt with real reform. As demonstrated by Spain, Portugal and Greece (and soon Italy), attempts at rapid reform have not produced sufficient structural change, merely crushed economic activity and tax receipts, making a bad position worse. Although some austerity measures are being legislated almost by accident, such as the agreement over the unnecessary crisis of America's fiscal cliff at the end of 2012, politicians know austerityis a vote loser, so will remain more wedded to rhetoric thanaction.
Consumption must increase modestly at best - too strong and interest rates will rise, as central banks tighten. Yet consumers may over-react to (minuscule) austerity measures, relatively low GDP growth and the gentle decline in real wages and living standards by reducing "unnecessary expenditure" which has been a major support of economic activity (do two-thirds of American and British homes need three or more televisions?). Consumption would again collapse but money printing would be ratcheted higher and, if necessary, central banks would make saving punitive. Both actions would favour equities.
The inflation rate must increase, but not too fast. Policy in the developed world is for higher inflation to erode the real cost of servicing government debt. If inflationary expectations get out of control, interest rates would have to be ratcheted up because of the risk of a collapse in the fundamental value of money and too high a savings rate. Yet in America the reverse is happening; the savings rate has halved to 2.7% as investors have fled money market and similar savings accounts at the fastest rate on record.
New Goldilocks has overturned traditional market theories; weak economic activity, financially incontinent governments and consumers stoically spending are all good for equity prices. Since the 1990s, Japan has demonstrated how a central bank trying to be prudent fails; perversely the reverse may apply. This is not to deny the risks in equity markets. Europe remains sick. In thefourth quarter of 2012 the Greek economy contracted by 5.7%, Spain's by 3%. Portugal's shrank for the ninth successive quarter. Tiny Cyprus is bankrupt. 40% of all Italians under 35 voted for are forming politician who had once made his living as a clown, 64% against EU interference and austerity. Italy is both the third largest Eurozone economy and global bond issuer. In America, arguments over whether to tax more or spend less have become less polarized, recognising both are needed. This increases the risk of accidental austerity. The fall in the Yen and rise in the stock market and consumer confidence in Japan have been driven by rhetoric alone. Without imminent action, deflation will return. China remains the major wild card; even its Central Bank has noreal idea of the size of the unstable "unofficial lending market" save it dwarfs all previous cycles.
Some offsets to these risks are technical; money flows into equities were weak for the last decade. They have clearly reversed. Many institutions have such low exposure that simple mean reversion underpins current prices, even before the universal hunt for income which is luring new and even private investors back into equities. Although valuations are elevated, as governments compete to fix the lowest interest rates and print the most money, no guide exists on how high valuations can rise. Go Goldilocks.
© Bedlam Asset Management
