Posts tagged ‘TMT / dotcom boom’
Among the many spectres raised to justify the current bear market, one of the most persistent is that of deflation. Some central banks, too, have referred to this unspeakable terror in an effort to legitimize their more exotic recent policy action. We had a look at the dove argument on inflation three weeks ago and challenged its tenets then. When it comes to outright deflation, however, we can also invoke the experience of Japan and ask the question: how close are other developed nations to a similar state?
To recap: Japan’s economy has been through hell since the collapse of the 1980s economic and investment boom. The stock market crashed in 1990, growth began to slow, and the Bank of Japan cut rates accordingly. The yen, however, was allowed to appreciate by over 50% on a trade weighted basis at the same time, more than compensating for this effect and ensuring a recession which saw growth move sideways for two years. This accelerated the pace of decline in the property market, which contributed to a major financial crisis.
Another period of massive yen appreciation followed in the wake of the collapse of the Asian tiger economies, which together with the collapse of the TMT boom saw the level of Japanese real GDP move sideways for five years this time (1997-2002). A period of respite followed – until the latest banking crisis, stock market crash, and now the earthquake of this year which has plunged the economy into recession yet again: the fifth episode of negative real year-on-year GDP growth in twenty years, which has seen the economy contract to its level of six years ago. Over the last two decades as a whole, real growth has averaged a barely perceptible annual rate of 0.7%.
Even with that cataclysmic, catatonic performance, persistent and significant price deflation has only occurred alongside the more savage contractions in growth. The nationwide CPI moved about 4% lower peak to trough after the 1997 collapse, and remained pretty stable thereafter until the credit crunch (so delivering annual inflation of zero, rather than deflation per se). This time it sank about 2% from end-2007 to end-09, since when it has again remained flat.
A diehard bear might well argue that a similar experience awaits the terminally doomed economies of the US and Europe. So rather than argue, let’s look at what this contractive, deflationary backdrop has meant for Japanese asset prices.
Interest rates have averaged 0.25% over the last ten years, decimating returns to cash. 10 year bond yields have averaged 1.4% over the same period (and traded in a range of about 1-2% since 1997). Equities have been rangebound too, though it is worth noting that the Nikkei rose to a peak 132% above its post-dotcom low in 2007, while the S&P 500 managed a mere 90% in comparison.
All of which suggests to this blog that cash rates and bond yields are already pricing in the Japanese experience across most of the developed world. Equity markets are the exception: while they are close to their 20-year lows, their valuations are way below Japan’s. (In the middle years of the last decade, the p/e on the Nikkei drifted around 30-40x – an earnings yield of 2.5-3.5%, which looks low but was generous relative to other classes of asset).
In other words, asset prices at present suggest the fear of something even worse than Japan’s lost decades. It’s arguable whether such a reality could possibly exist. But you can’t argue that it’s a properly bearish view.
It was one of Mr Bernanke’s predecessors at the Fed who said that his role in setting monetary policy was “to take away the punch bowl just as the party gets going”. The current Fed chairman appears determined to wait until festivities are in full swing, but he will have to start taking away that punch at some point, and there are worries that this will leave equity markets with a sore head.
We have already seen that higher rates need not necessarily mean lower stocks when it comes to developing economies. But how has the US market reacted to post-recessionary policy tightening in the past?
In the early 1980s a hawkish Fed pushed interest rates to 20% in an effort to contain inflation. It succeeded – at the expense of a recession that saw rates fall all the way to 8.5% by December 1982. The Fed stayed its hand for a while before tightening again in May the following year to a peak of 11.75% by August 1984.
At the bottom of this cycle – from the beginning of December 1982 to the end of May 1983 – the S&P 500 returned 19.9%. And by the time rates peaked – from end May ’83 to end August ’84 – it had returned another 8.6%.
Moving on to the post-recessionary tightening cycle of the 1990s, rates bottomed at 3% (Sep ’92), began to rise in Feb ’94 and peaked at 6% in Feb ’95. And the S&P returned 17.6% while rates were held low and a further 7.4% during the period of tightening.
Finally, while the US economy didn’t experience a technical recession in the wake of the TMT / dotcom crash, it did contract in the first and third quarters of 2001 and the Fed eased policy accordingly. This time rates didn’t bottom out until June ’03 (at 1%); they stayed there until June ’04 before rising to a peak of 5.25% in June ’05.
While rates were at the bottom that time the S&P returned 20.6%, and a further 15.5% during the period of tightening.
Time for some provisos!
- The UK had a mini tightening cycle from Feb 1994 to Feb 1995 too: the stock market returned -11% over the period.
- The US equity market has already returned 50% since the Fed funds rate bottomed in December 2008.
- The 1980s and 1990s were periods of exceptionally high returns for equity markets for many reasons besides the level of interest rates.
The one conclusion that it is safe to draw from all this is that investors should not necessarily expect stocks to respond to monetary tightening in a one-dimensional way. Taking away the punch doesn’t always ruin the party.
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.