Markets Insight

April 8, 2014 8:42 am

Time running out for the market riggers

Demand for safe and risky assets has left both looking highly valued

Conventional wisdom has it that the long-term global decline in real interest rates owes much to an increase in the demand for safe assets.

Certainly it is true that the accumulation of official reserves by excess savers in the developing world has played an important role and with the eurozone breaking into current account surplus there is now a new excess saver on the block.

At the same time the increased real return required by equity investors since the dotcom boom and the great financial crisis has reinforced a portfolio shift towards bonds, resulting in further downward pressure on yields.

Yet the more striking thing about today’s markets is surely the extraordinary demand for unsafe assets.

In the credit markets junk bond yields are close to record lows. Securitisation is back in fashion in a big way. There is a slide afoot in lending standards, with a reversion to such pre-2007 bad habits as payment-in-kind notes and “cov-liteloans that provide poor protection for investors.

Mexico, admittedly with a good domestic economic story to tell, managed to sell a 100-year sterling bond last month on a coupon of 5.75 per cent. At the same time the yield on Spanish and Irish sovereign five-year bonds last week fell below comparable US Treasury paper.

Central bank intervention

That is quite a tribute to the power of the central banks, which have rigged the market in spectacular fashion. Mario Draghi at the European Central Bank has even done it on the cheap, putting up no money via the ECB’s outright monetary transactions programme to support his assertion that the ECB would dowhatever it takes” to save the euro.

At the same time he has promoted a carry trade whereby banks have borrowed cheaply from the ECB to buy eurozone sovereign debthence the fancy ratings for Spain and Ireland, among others.

In the US, the UK and Japan, meantime, the resort to quantitative easing has succeeded in stirring investors’ appetite for risk, even if its impact in the real economy has latterly failed to impress. Equity market valuations, too, reflect this prestidigitation.

As Richard Fisher, president of the Reserve Bank of Dallas, pointed out last week, the price/earnings ratio of stocks was among the highest decile of reported values since 1881, while the economist Robert Shiller’s inflation-adjusted PE ratio had reached 26 as the Standard & Poor’s 500 hit yet another record high.

That compares with a ratio of 30 before Black Tuesday in 1929 and an all-time high of 44 before the dotcom implosion at the end of 1999.

Since bottoming out five years ago, the market capitalisation of the US stock market as a percentage of the country’s economic output has more than doubled to 145 per cent – the highest reading since the record was set in March 2000. It is hard not to believe that valuations are running ahead of earnings prospects.

Corporate manipulation

Another indication of fierce risk appetite is the rise in margin debt. This has been setting historic highs for several consecutive months and, according to the latest data from the New York Stock Exchange, now stands at $466bn. That is double the level at the start of 2010.

The central bankers are not the only ones to have successfully rigged the markets. Executives in the quoted corporate sector in the English-speaking world have been borrowing furiously at low rates of interest to buy back equity. As well as pushing up share prices the resulting reduction in the number of outstanding shares causes earnings per share to increase even when there is no increase in revenue or improvement in profit margins.

This, of course, leads to a boost to bonuses and other equity-related incentives based on performance yardsticks such as earnings per share and return on equity that bear no strict relation to value creation.

Does this mean, contrary to Margaret Thatcher’s famous assertion, that you can buck the market? Well, yes and no. There is an issue of timing. In effect, central bankers have been repeating the trick used repeatedly by former Fed chairman Alan Greenspan of asymmetric activism.

When markets bubbled, Mr Greenspan’s Fed failed to curb the euphoria, but when they collapsed the central bank came to the rescue. Under his successors we are witnessing more of the same but on a colossal, experimental scale.

The coexistence of strong demand for both safe and unsafe assets is not a coincidence. As in the period before 2008 low nominal and real interest rates have driven investors into a search for yield. That is now, once again, associated with a decline in bank lending standards, as people are lulled into complacency by low default rates.

It brings to mind the adage: if it’s too good to last, it will stop.

Copyright The Financial Times Limited 2014

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