With short rates at record lows and negative yields on bonds, all the stockmarket has to do is not look like a disaster
By Buttonwood
WHAT explains the recent highs in the American stockmarket? One explanation is that the markets were nervous over the British referendum on the EU; before the vote, it was cited as the biggest risk in the markets by 30% of fund managers in a Bank of America poll. After the vote, however, investors seem to have concluded it is mainly a UK and EU issue; indeed even in the latter, it does not yet seem to be inspiring other countries to depart. So investors who were sitting on the sidelines have piled back into equities.
However, the Brexit vote did drive government bond yields lower, pushing those in Germany and Switzerland even further into negative territory. And it seems likely to inspire a rate cut in Britain and may cause the Federal Reserve to hold fire on further rate rises for a bit longer. In other words, the returns in cash and bonds are pretty dismal.
In the circumstances, equities look like the only game in town. so the outlook would have to be absolutely dreadful for investors to avoid them. And it's not dreadful. The Atlanta Fed thinks that US GDP grew at an annualised 2.3% in the second quarter; after a weak May, the non-farm payroll numbers in June were strong.
The results season for the second quarter is just starting. Forecasts are for an annual decline in earnings per share of 5%. That's not great. But BNP Paribas points out that, on a quarterly basis, earnings will be higher than in the first three months of the year. The impact of the oil price collapse and the dollar's rise on corporate profits may be fading. In valuation terms, the cyclically-adjusted price-earnings ratio is 26.2. That is high by historical standards. But, of course, yields on bonds and cash are exceptionally low by those same standard. So stocks look like the "least dirty shirt" on the washing line.
Another factor may be that central banks are still pumping out liquidity; they may not be buying equities directly but by forcing investors out of bonds, they are boosting the stockmarket. Matt King of Citigroup notes a close correlation between central bank asset purchases and the global equity market.
What will it take to drive the stockmarket down on a more sustained basis than was seen in, say, February? It remains my view that this will not happen unless there is a recession in America (or more generally in the developed world) or a sharp rise in interest rates. The latter looks highly unlikely at the moment. And while the world economy is hardly booming (see the latest numbers on Chinese trade), it is still muddling along. None of this means the returns on equities will be very high in a world of slow growth, of course, especially given the starting valuations.
