HIGH HOPES, LOW RETURNS / THE ECONOMIST ( A MUST READ )

Financial markets

High hopes, low returns

Equities struggle in the face of sluggish rich-world growth

Aug 6th 2011
from the print edition

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MANY equity investors started 2011 with high hopes. Interest rates were low and set to remain so; corporate profits were strong; and the buoyancy of emerging markets would offset any lingering weaknesses in the developed economies. At Goldman Sachs’s global strategy conference in January, an upbeat Jim O’Neill, the boss of the bank’s asset-management arm, struggled to imagine what arguments the bears could possibly assemble.

Quite a few, as it happens. After the first seven months of the year global stockmarkets are in effect flat (see chart 1). Despite a last-minute deal on the US debt ceiling, a sharp fall on Wall Street on August 2nd meant that the S&P 500 had lost all its gains for the year. In Europe the mood has turned very sour: the Euro Stoxx 50 index is down by 17% from its February high, and the Italian market has fallen by almost 24%.


What has gone wrong? The economic data have been a severe disappointment to the bulls. Revisions published on July 29th show that American economic output is still below its 2007 level. At the start of the year the consensus forecast for American GDP growth was 2.6%, but the annualised increase in the first half was just 0.8%. Bank of America Merrill Lynch has cut its full-year forecast to 1.7% and is predicting 2.3% for 2012, barely in line with trend.


Some of this weakness was attributed to the impact of the Japanese earthquake in March, which disrupted output in the world’s third-largest economy. But that explanation is wearing thin. Japanese activity is now rebounding but the data in much of the developed world are still deteriorating. The latest source of gloom was the July Institute for Supply Management (ISM) index for American manufacturing. At 50.9, the index was barely above the line that separates expansion from contraction; the new-orders component was below it.


David Rosenberg, an economist at Gluskin Sheff, a Canadian asset manager, has consistently raised doubts about the strength of the recovery. He points out that the 9.5-point decline in the ISM index over the past three months is similar to falls that preceded each of the past six American recessions, with only one false signal in 1984.


Another problem has been the continued strength of the oil price. This surged in early 2011 on the back of the conflict in Libya. Many analysts expected it to drop back in the following months but Brent crude is still around 25% more expensive than it was at the end of 2010. For consumers the key number is the price of petrol at the pump: in America it has risen by 67 cents a gallon, or 22%, so far this year.


Normally a weakening economy leads to a fall in commodities. But their prices are still double their level in December 2008 (as measured by The Economist’s all-items index), indicating that prices are now set not by Western consumers but by those in the developing world. This shift of economic power creates another headwind for Europe and America.


Chris Watling of Longview Economics, a consultancy, points out that commodity and equity markets seem to be negatively correlated. The commodity boom of 1968-80 coincided with a bear market for equities. As raw-materials prices fell in the 1980s equities started a long bull run, peaking in 2000. Commodities have since taken off again, and the MSCI World stockmarket index is below its March 2000 high.


The inability of developed-world governments to put their debt worries behind them has added to negative sentiment. Attempts by the euro zone to solve its debt crisis have conspicuously failed. Greece, Ireland and Portugal are still unable to borrow long-term funds; worse still, the contagion has spread.


Many bond investors thought that yields would rise as the global economy recovered. But outside the euro periphery, rich-world yields are below where they were at the start of the year. Long-term British bond yields are at their lowest since 1946. In America the ten-year Treasury-bond yield fell even as Congress flirted with default.

That is not too surprising. Treasury bonds are still the most liquid market in the world. America for now retains its AAA rating from the big three agencies (although Dagong, a Chinese outfit, downgraded it to A on August 3rd) and there are no other highly rated assets of comparable size (see chart 2). Investors are nonetheless seeking other havens. The Swiss franc is up against all main currencies, prompting the Swiss National Bank to cut interest rates almost to zero on August 3rd; the Japanese authorities intervened the following day to weaken the yen; gold has risen by 18% this year to a new nominal high of $1,672 a troy ounce.


The current crisis of confidence was probably inevitable given the events of recent years. Governments and central banks stepped in to rescue their banks and economies by allowing budget deficits to surge, slashing interest rates and introducing quantitative easing (QE), the creation of money to prop up asset markets. In an ideal world these measures would have been used only temporarily, until the private sector took over as the engine of growth. The ability of governments to deliver continued stimulus has since been hurt by political opposition to big deficits and, in some places, by market nerves. That puts the onus on central banks to keep interest rates low (and, perhaps, do more QE).


Given this gloomy context the doubling of the S&P 500 since its March 2009 low, and the market’s high cyclically adjusted price/earnings ratio—22.2, according to Robert Shiller of Yale, compared with an historical average of 16.4—make American investors look overly sanguine. Wall Street still has the support of buoyant corporate profits, thanks to foreign earnings and cost-cutting. According to Standard & Poor’s, second-quarter earnings for S&P 500 companies are on track to reach $25.12 a share, beating the record set four years previously. If the economic outlook keeps deteriorating, that will not last.