Buttonwood
Something's gotta give
Nov 19th 2009
From The Economist print edition
Either central banks are wrong to keep rates low, or markets are wrong to expect recovery
Illustration by S. Kambayashi
LIKE a truck rolling downhill, the rally in risky assets is proving hard to stop. Good economic news causes share prices to rise because it indicates the recovery is robust; bad economic news also causes prices to rise because it signals that central banks will keep interest rates near zero.
Those low interest rates have probably been the main driver of the rally, encouraging investors to put their cash to work in search of higher returns. But other factors have been at play. Forecasts for corporate profits have been revised steadily upwards as analysts anticipate the benefits of economic recovery.
This has been a revival in the bottom, rather than the top, line. According to Morgan Stanley, non-financial stocks in the S&P 500 beat third-quarter earnings growth estimates by an average nine percentage points. But the companies’ sales fell around a point shy of forecasts. A similar pattern was seen in Europe.
In short, companies have used the crisis to achieve a remarkable expansion in margins. Tim Bond of Barclays Capital reckons that, on one measure, the improvement over the last two quarters has been the best since the second world war. The trick has been the corporate sector’s success in controlling labour costs; in the third quarter, operating costs for non-financial S&P 500 companies were down by 32% from the previous year.
But the weakness in earnings and the job market means that consumer confidence is far from robust; the University of Michigan sentiment survey has fallen in each of the last two months. Nor are consumers borrowing to maintain their spending; instead they have been repaying their debts.
American retail sales were stronger than expected in October, thanks largely to the car industry. Even so, they were still down on the same month last year. The decline might have been worse had homeowners not benefited from the sharp fall in mortgage rates.
Against such a background, how long can an improvement in corporate profits be maintained? Cutting costs makes sense at the individual company level but not in aggregate; one company’s sacked worker or pay freeze translates into another company’s sluggish demand.
That may explain why the improvement in profits is not translating into a splurge of capital expenditure. Nevertheless, in the short term the revival in corporate profits is adding to the sense of recovery. Companies seem to be taking the chance to improve their balance-sheets, building up cash reserves instead of repaying bank debt; commercial and industrial loan books are still contracting. And with companies having little need for more debt, banks are indulging their appetite for buying government bonds.
This strategy (with the help of central banks’ purchases of bonds) is helping to hold down yields, making it easier for governments to finance their deficits. With inflationary pressures still very low (American core producer prices rose just 0.7% in the year to October), there is very little need for the Federal Reserve to raise interest rates in the near future. The cost of borrowing for six months in dollars is now lower than the cost in yen, something that would have been unimaginable just five years ago.
Instead, the main threat to the rally seems likely to be disappointing growth, at least in the developed world. American industrial production rose just 0.1% between September and October and a number of other industrial-activity figures have been disappointing. The Economic Cycle Research Institute’s leading index slipped to an eight-week low in the week to November 6th.
Meanwhile, the Chinese boom that seemed to revive the global economy is showing its dark side. Commodity prices are rising across the board, acting as a further tax on hard-pressed Western consumers (oil has roughly doubled since the start of the year). In some countries, particularly in Europe, actual taxes are starting to rise as well, as governments grapple with their fiscal deficits.
At some point, the central dilemma at the heart of this rally will have to be resolved. Low interest rates seem like good news for investors. But why are central banks holding rates so low? Either they are correct in assessing that the economy is still fragile, in which case corporate profits will ultimately disappoint. Or they are underestimating the strength of the recovery, in which case inflationary pressures will start to emerge (and bond yields will rise sharply). Markets will have a tricky time navigating between this Scylla and Charybdis in 2010.
Copyright © 2009 The Economist Newspaper and The Economist Group. All rights reserved.
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