Archive for August, 2010
A question we have been asking of bond yields lately. Buoyed in part by the lacklustre performance of equity markets this year, and apparently by all that talk of “double dip”, bond yields have in some places reached record lows.
The UK is no exception. The benchmark ten year gilt closed at 2.79% on Wednesday – a new all time record low, lower than the 2.95% seen in March 2009 and lower than inflation (by 0.2% on the official CPI measure and almost 2% on the old RPI). It is also lower than the dividend yield on the FTSE All Share Index – substantially so, as the latter stands at 3.4%.
Ten year rates are not alone, with thirty year yields of around 3.85% within sight of the all time low of 3.7% seen at the end of 2008. The index linked market has been pushed higher amid the fray as well, with the real yield on the 1.25% 2017 flirting with negative territory for the first time.
All this looks a bit like hysteria to us. Bonds yielding less than inflation? Less than equity dividends? Less than they did in the teeth of the severest recession since the Second World War?
Of course, much of this was true half a percent ago. And nobody knows how far the forces behind the recent rally may continue to push it.
So let’s remember a few details outside of the valuation picture too. Like the £200bn of gilts sitting in the Bank of England’s vaults that will have to be sold into the market at some point. Or the c. £150bn on course to be borrowed by Her Majesty’s Government this fiscal year, and the substantial borrowing to come in the years after that. (Ten years ago, £200bn was the size of the entire gilt market, excluding index linked.) And the base rate, still being held at an unprecedented emergency level, won’t stay there forever.
These headwinds, combined with the terrible valuation data, surely present the bleakest of outlooks for the gilt market. The trend may be your friend, but in the case of the bond market, we’d say it’s the only friend you’ve got.
One of the key drivers of the poor performance of equity markets in the second quarter was the perception that action taken by the Chinese authorities to take steam out of the economy would threaten world growth. The release of continued upbeat data from China this week prompted us to consider how realistic those concerns are looking a few months down the line.
It is true that there are more question marks than usual over Chinese economic reports. Not every country has to impose penalties on officials who are caught falsifying statistics. Can an economy whose latter day prosperity was established as the workshop of the world really have been insulated from the collapse of its export markets to the extent that it grew by over 9% in both 2008 and 2009? If so, the country really is a riddle, wrapped in a mystery, inside an enigma.
Taking the data at face value, however, as we must, this week’s numbers are of a pattern with recent releases that together suggest an economy in rude health. Some July numbers released over the last couple of weeks are admittedly lower than they were a month ago. Annual growth in exports: 38.1% (down from 43.9% in June). M2 growth on the year: 17.6% (18.5%). Retail sales: up 17.9% on the year (18.3%). Increase in industrial production over a year ago: 13.4% (13.7%) … The list goes on. So while it may be true that the numbers are technically showing signs of slowing, the conclusion must be that China continues to expand at a breakneck pace. (This is of a piece with the situation in developed economies too – as we wrote a week ago, an easing off in growth rather than a “double dip”.)
What does this mean for markets? Well, for one thing, fears in the spring of a pronounced policy-driven slowing in China look to have been overdone. And if equity markets continue their recent falls on growth concerns, that would look overdone to us as well.
There has been a lot of talk of late about the possibility of another recession – an economic “double dip” – at home and abroad. Even today, as the Eurozone posted GDP growth for the second quarter of a more than respectable 1.0%, markets sold off and the euro weakened, apparently on the back of this concern.
What is going on?
In our view, two things are being confused. On the one hand, authoritative sources such as the Fed and the Bank of England have recently downgraded their growth forecasts. What they are absolutely not doing, on the other hand, is suggesting that growth will turn negative again, which is what some observers seem to be (over) extrapolating from their actions.
It is well known that the global economy faces headwinds. There are doubtless more disaster stories in the pipeline, from unemployed homeowners being dispossessed to nation states facing bankruptcy. But across the world as a whole – and even across America as a whole, or across Europe – all indications are that while the pace of growth might well ease off, it will stay positive and the recovery, however tentatively, will progress.
Things do change of course. The data is not yet available but it seems likely that the Eurozone’s strong performance will have been driven in part by an increase in exports as the euro has weakened by almost 10% on a trade weighted basis since the beginning of the year. An equivalent strengthening in the currency could well see some of that effect reversed. And economic forecasting, as we have observed, is an intractable business at the best of times.
For the moment, however, and knowing what we know, it is our view that the world should take its central bankers at face value, and that talk of a renewed period of negative growth seems … well … Dippy.
Among the most interesting data available to follow are historic stock market earnings. (Well, when we say available, if you have access to a source of historic price / earnings ratio data for a given equity market index you can invert it to give an earnings yield and then multiply this yield by the index level (price) to give reported earnings for that market.) They give a picture of corporate health across entire countries or regions, depending on the index used, and are a useful shorthand for what investors in equity markets actually own.
Corporate profitability is a volatile and vulnerable quantity. In the wake of the dotcom boom for instance, reported earnings for the S&P 500 sank to multi-decade lows in real terms, before recovering again after only a few years.
These reflections were prompted by the news this week that BP’s “static kill” operation appears to have succeeded in permanently sealing its damaged well in the Gulf of Mexico. On the day that BP reported its record second quarter loss – 27 July – historic earnings for the FTSE All Share Index fell by 13%.
BP was not the only company reporting that day, of course, so if the recent (upward) trend in earnings was reflected across the wider market on the same day the figure of -13% would understate the impact of that single company’s reported earnings on the entire index.
Looking at that index-level data alone would not provide enough information to distinguish between a market level event, such as the collapse of the 1990s technology valuation bubble, and a (mere) stock level event such as the evisceration of BP.
As it happens, in the week or so since, earnings in the UK market as a whole – notably in the major banks – have risen to such an extent that they have now returned to their level of July the 26th.
All of which goes to show that it behoves any user of economic and market data to remember that every wood is made up of a series of trees: it is not advisable to base decisions on any aggregated series without considering its component parts.