Why are stock markets going up so much? Why are stock markets going up so much?

Investors peering at the record levels achieved by the UK and US stock markets, and comparing it with the far more pedestrian GDP growth rates must be asking, can it last?

 Why are stock markets going up so much?

Cole is invested in Japan and the Eurozone

The major reasons why equities have shot up since last Autumn are technical, and only partly related to the wider economy.

It was the under-reported action of the Bank of Japan in the third quarter of 2016 gave market participants pause for thought.

The central bank announced its intention to target zero per cent as the yield on its ten year bond.

That pushed the yields on other developed market government bonds upwards.

Such a sell-off in bonds was not in the script for the legion of investors who had parked their cash there in recent years as a safe haven, promptly fled towards equities.

The actions of the Bank of Japan implied that inflation would be a little higher, bonds as an asset class tend to perform less well when inflation is rising.

This is because the income from most bonds is fixed, so the purchasing power of that income erodes as inflation climbs.

In contrast, the income from a share can move up alongside inflation.

In the immediate aftermath of the UK’s vote to leave the EU, predictions of an impending recession swept through markets.

Bank of England governor Mark Carney was swiftly out of the hallowed halls of Threadneedle Street and in front of the TV cameras to declare that interest rates would be cut to another record low level of 0.25 per cent and a fresh bout of quantitative easing.

Read more: How does quantitative easing work? 

Whether those actions have played a role in the better than expected GDP numbers for the UK is a matter of debate.

But economic theory advocates that lower interest rates should generate inflation in the economy, as the incentive to save is reduced, and borrowing becomes cheaper.

Both of those effects are designed to stimulate economic activity and inflation, enhancing the appeal of many equities.

The cut in interest rates also serves to excascerbate the already stark fall in sterling. The fall in the value of the pound pushes up the cost of imported goods, which caused inflation.

But the rise to record levels of the FTSE 100 and FTSE 250 is not just the consequences of what might be called ‘bad’ reasons.

Significant economic data for the UK, such as Purchasing Manager Index (PMI) surveyors and core inflation, have pointed to an economy that has years of growth ahead.

That is a positive for many of the sectors of the UK market, such as housebuilder shares, which are acutely sensitive to the wider economy.

Bank shares have also done well, both because of the revised economic outlook and the rise in bond yields. Banks are big winners from higher bond yields because they are required by regulators to hold liquid assets such as bonds, a higher income from those assets is good for bank profitability.

International Factors.

It is an oft-made but very prescient point that the FTSE 100 is an international index, with 70 per cent of the earnings achieved by companies on that market being from overseas.

Some UK stocks have benefitted simply from the cash they earn abroad being worth more when translated back into sterling. That has supported the dividends, and so valuations, of many of the largest companies on the UK market.

Recent data also painted a positive picture for UK exports, as companies selling overseas win new customers through the currency being cheap.

Read more: Mark Carney: Brexit won’t cause recession in the UK

It is an oft-quoted economic adage that a country cannot attain long-term economic prosperity simply through having a cheap currency.

That’s because the concordant rise in inflation eventually feeds through to consumers, as wages fail to keep up with rising prices, and so consumer spending falls.

Amid the doom and gloom, it is somewhat forgotten that in the most recent set of wage data showed wages rising faster than inflation. Stephanie Flanders, the former BBC Economics Editor who is currently chief market strategist for Europe at JP Morgan Asset Management has been highlighting the improved PMI data for some time.

So the economy is presently in a ‘goldilocks’ situation where exports are cheap, but wages are still rising.

That feeds through to both the companies that are export-led, and those that are domestic-consumption led, delivering decent results.

Part of the reason for the market having previously priced in such a negative outcome for the global economy, and stock markets, is China.

Policymakers in that country long ago realised that the intensive export led growth which has driven their economy in recent years would not last, and have tried to orient the economy back towards consumption.

That was expected to lead to a lower overall growth rate, and be bad for commodities.

But while investors such as James Syme at JO Hambro, take the view that China’s current approach will fail, the worst of the outcomes priced by global investors have not happened. That has contributed to global inflation expectations moving upwards.

Better than expected economic data from China has led to global commodity and oil prices to rise after a period in the doldrums.

Commodity and big oil companies, of which there are plenty in the FTSE 100 have therefore enjoyed considerable share price gains.

If investors such as Syme and Jason Hollands at Tilney Group take the view that China is headed for a hard landing, they view it as more medium term, certainly not enough to dissaude investors from the mining shares, which has contributed to the strong performance of the FTSE 100.

Read more: James Syme: A crisis is coming to China, but there are profits to be made

If the mining and oil companies have been in the vanguard of the FTSE 100’s revival, in the US it has been bank shares.

That is partly a function of the same rising bond yield trend that has helped the UK banks, but there is more to it.

The US economy appears to be in sufficiently robust health that the Federal Reserve, the central bank of the US, is likely to put interest rates up this year.

Higher rates allow banks and insurance companies to attain higher profit margins.

The third great inflationary force that is expected to unleash upon the world is ‘Trumpenomics.’

Donald Trump has made as a central plank of his time in the Oval Office a wave of infrastructure spending.

Such an action will lead to higher a higher government budget deficit, and higher inflation.

David Jane, a multi-asset investor at Miton Group, told What Investment that ‘it doesn’t actually matter’ whether the policy of ‘Trumpenomics’ actually works, a short term bout of inflation will ensue.

The economic performance of many of the Eurozone countries has also been better than forecast, providing the market with fresh reasons for optimism.

So will it last?

A concern for investors will be that when stock markets are at such elevated levels, it doesn’t take much for sentiment to snap back.

Peter Elston, chief investment officer at Seneca, has avoided buying US shares for some time, commenting that the economic data points to an economy that is in the late stage of the economic cycle, and so has little room for upside.

Read more: Peter Elston: Why I’m shunning US shares

The hypothesis underpinning Elston’s view is that with employment rates already high in the US, extra stimulus is unlikely to make a great deal of difference.

Read more: Lombard Odier: Why US shares are poor value in 2017

James Carrick, economist at Legal and General goes a stage further, believing that a short recession is on the cards as debt levels have risen.

Read more: James Carrick: Recession is just around the corner

In the UK, whilst wages are presently rising faster than CPI inflation, wage growth slowed last month, while inflation is, in the short-term, likely to go up. When the two lines on the graph cross each other, and inflation rises faster than wages, consumer demand in the economy is likely to slow. Consumption accounts for two-thirds of UK GDP.

Read more: The sectors to avoid as inflation rises

At some point the excessive leverage in China will have to have an impact, exporting deflation around the world.

 

 

    

 

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