Archive for February, 2012
Each year, Barclays publishes its Equity Gilt Study. Among other things, this magisterial document records inflation-adjusted total returns to UK shares, gilts and cash for each year since 1899. On average, government bonds have returned something in the order of 1-2%, plus inflation, per year. Last year’s returns of 17% – or 21% in the case of index linked gilts – can therefore be regarded as anomalous.
They have also left gilts offering dismally poor value. Ten year yields have been hovering at about 2%, in line with the Bank of England’s supposed target for CPI inflation, and significantly below the most recently reported level of 3.6%. Most starkly, perhaps, all yields on index linked gilts with maturities shorter than twenty years are negative. An investor buying the ten year index linked benchmark and holding it to maturity would be locking in an annual real return of -0.5%.
Gilts, of course, have been seen as a safe haven from the storm that rocked European bond markets over the autumn. They have also enjoyed ongoing support from the Bank of England’s programme of quantitative easing, and from expectations that the base rate will not rise until some time in 2014.
While peripheral eurozone bond markets continue to attract scrutiny, however, the fact is that they have made a strong recovery over the last few weeks. Interest rate expectations change: twelve months ago, the same futures markets that are betting on unchanged rates for the next two years were expecting an increase of 2.5% over the same period. And the Bank will not buy gilts forever. (Indeed, even the increased size of its asset programme at £325bn pales next to the £594bn of net gilt issuance which the Debt Management Office expects to have completed since the start of the recession – see here for the conceptual logic of this.)
It is looking more and more as if the world has moved on from the rabid bearishness of a few months ago. So far, the gilt market has yet to move with it. It puts this blog in mind of the staple gag in those old Hollywood cartoons where a character runs off the edge of a cliff without noticing and manages to defy gravity for a few impossible seconds, legs paddling furiously in mid air, before looking down and giving in to the inevitable.
Of course, a world calamity that sees the UK collapse into deflation could entail some more upside for the bond market. (The ten year government yield in Japan is 0.98%.) Without such an outcome, however, gilts are surely poised to fall some distance before they reconnect with reality.
It was the height of summer, 2011. The Arab uprisings and Great East Japan Earthquake had already made for a nervous start to the year. In Europe, new bailout terms for Greece were failing to contain fears of a sovereign credit event, expected by many to trigger catastrophic financial contagion. And then at the end of July, growth figures for the US economy were revised down in the middle of tense budget negotiations that threatened government insolvency.
The result, as we know, was meltdown. The world watched in horror as the perfect storm unfolded under the influence of events on either side of the Atlantic. It was as if the US and Europe were planets that had aligned to exert a baleful influence on the world economy.
Today it is clear that there has been a realignment. The Greek circus limps on and Europe retains the power to terrify. At the same time, however, a consistent stream of positive economic data from the US has laid the spectre of a double dip recession to rest. The planets seem to be pulling in different directions.
Markets yesterday were a case in point. With the latest agreement on Greece delayed, the FTSE 100 index swiftly fell by over 1% in early trading. Relatively little of this loss had been given up by lunchtime. And then at half past one, employment and housing data from the US showed more of an improvement than the consensus was expecting. US index futures spiked up and London began to recover some ground.
On the New York open (2.30 pm GMT) the S&P 500 started out flat. Then at 3 pm, there was more positive data on the US mortgage market and business conditions. American markets began to rise, taking Europe with them. At 4.30 pm the FTSE 100 closed the day pretty much unchanged.
The question seems to be, who will win the tug of war: the US, or Europe? Into the orbit of which planet will we be drawn?
It is hardly worth saying that a cataclysm from the eurozone could upset the apple cart – though with bond yields in peripheral countries way below their November peaks the market is taking the view that this risk has reduced. And if Europe does continue to avoid out-and-out disaster, then at some point it is possible that the background to last year’s crash will be exactly reversed: US growth will be stronger and fears over sovereign debt will recede.
Time, as ever, will tell.
Shares have enjoyed a strong start to 2012. The MSCI World Index of developed country stock markets closed yesterday up 6.5% on the year so far. The Emerging Markets index has done even better, closing up 13.9%. And yet looking at the headlines one might think this overdone. Banks in particular seem to be suffering, with Deutsche Bank for example reporting a 76% collapse in profits only yesterday. Last year markets were arguably too pessimistic in the face of mixed economic data and robust corporate earnings growth. Could they be growing too bold at present and overreacting the other way?
Let’s look at the S&P 500 index. Fourth quarter earnings season in the US is well underway, with just over half the members of the index (273 companies) having reported as of yesterday. Earnings per share for those companies rose 3.5% on the quarter, falling short both of analysts’ estimates (+4.8%) and the 5.4% rise in the index itself. On the face of it this could be taken as a sign of over-optimism.
Digging a bit deeper, however, we find that if we exclude results from the financial sector – which has posted a fall in EPS of over 18% so far – non-financial companies have reported an increase in earnings of 8.2% (against a forecast of +6.5%).
What is important about this is that it is the big banks which were most exposed to last year’s market turmoil. If Deutsche’s investment banking division, for example, had broken even over the quarter instead of posting a €422m loss, profits across the bank as a whole would have beaten analysts’ estimates. We have seen similar stories in US bank results, where poor performance from the market-exposed parts of the business masked continued modest improvements in key bread-and-butter measures such as the size of provisions for loan losses.
Even if we choose to ignore this level of detail, however, stock market indices have a long way to go before they begin to look overvalued. For example, the p/e ratio of the FTSE 100 index has averaged about 14 over the last ten years. Even assuming earnings growth of zero, to match this valuation from the current p/e level of 10.4 would require growth in the index of some 35% – a rise in price to over 7,800.
Of course, it is still possible that some kind of catastrophic collapse will overtake us, and market valuations reflect that fact. But it is at least equally possible that calamity is avoided, that the world’s tortuous recovery continues its uneven path and that over time even the wounds of the banking sector will heal.
The rally in equities so far this year has been swift, and rather surprising. Based on what we know about the valuation of stock market earnings, however, it is too early to say that price levels have got ahead of the fundamentals.