Markets have defied expectations in 2014, leaving investors with few options
THIS was supposed to be the year when normal service resumed in the global economy and markets. As the recovery picked up steam, shares were expected to continue their rally and government bonds were projected to lose value (which would make the yield they pay rise), according to the consensus view.
But that is not what has happened. As of August 11th the Dow Jones Industrial Average was fractionally down on the year (the broader S&P 500 was up) and there were losses for the FTSE 100 in Britain, the CAC 40 in France, the DAX in Germany and the Topix 500 in Japan. Government-bond yields were testing historic lows, particularly in Germany, where the ten-year yield had dropped to 1.06% from 1.93% at the end of 2013; the yield on the equivalent Treasury bond had fallen to 2.42% from 3.03%.
The reasons that equity and bond markets have not conformed to the consensus view are many. First, some markets had a bumper 2013—Wall Street rose 30%—and investors started the year in excessively optimistic mode. Second, there has been gloomy economic news. America had an extremely disappointing first quarter, with GDP falling at an annual rate of 2.1%. Though it rebounded in the second quarter, the same cannot be said for Europe. Italy is back in recession and the German ZEW index of economic confidence fell sharply in August. Japan’s GDP dropped 6.8% in the second quarter on an annualised basis, and recent data from China have been weaker than expected.
Third, the sluggish global recovery means there continues to be very little inflation; indeed, in Europe, where prices rose 0.4% in the year to July, deflation looks more of a problem. That helps to explain the bond market’s strength: very low nominal yields are still positive in real (after inflation) terms. Fourth, geopolitical risks—the conflict in Ukraine, the battle between Israel and Hamas in Gaza and the rise of extremist forces in Syria and Iraq—have caused markets to wobble on several occasions.
Finally, investors are worried about the effect of central banks’ impending withdrawal of life support. The Federal Reserve is due to stop asset purchases in October and a rate rise from the Bank of England is looking likely in the coming year. This is perhaps the most crucial factor, given the way that low returns on cash have encouraged investors to buy risky assets like shares and corporate bonds. “Financial markets have been manipulated on a global scale by central banks,” says Ross Pamphilon of ECM, a bond-fund manager.
Over the past five years, the effect of central-bank policy has been to make valuations seem almost irrelevant. A poll by the society for British chartered financial analysts found that 55% of investors believed equities in rich countries were overvalued. However, that still made shares better than the most common alternatives: government bonds (75% thought those were too pricey) and corporate bonds (72% felt they were overvalued).
This unappealing choice may explain why, despite all the worries, stockmarkets’ losses this year are still so modest. A survey of global fund managers by Bank of America Merrill Lynch found that, although they have cut their exposure to shares and increased their weighting in cash, a net 44% of investors still have a bigger exposure to equities than normal.
In a sense, stockmarkets have defied gravity. Central banks slashed interest rates (and introduced quantitative easing) because they feared the economy would be weak; the economy has indeed been weak. But profits have been strong. As the chart shows, American profits rebounded quickly from their collapse in late 2008. They are close to a post-war high as a proportion of GDP, even though they fell slightly in the first quarter.
The main factor has been an increase in margins; sales per share are barely higher than they were six years ago. The sluggish performance of real wages has kept costs down. But another factor has been companies’ use of their spare cash to buy back their stock. This makes earnings per share rise faster. American firms announced buy-backs worth $671 billion last year, or about 3.9% of GDP, and have made plans for nearly $300 billion this year, according to TrimTabs, a data service. That is more than four times the money placed into equity funds by retail and institutional investors.
Like a snake swallowing its own tail, the corporate sector is absorbing its own equity. How long this can continue is anyone’s guess. The peak year for share buy-backs was 2007, just before the debt crisis. That is not a great omen.
