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Recent Rises In Stock Markets Are Not Justified By The Economic Evidence

The Economist
August, 2003

In New York, London and most other financial centres, two opinionated groups have been holding forth of late. On one side are the miseries who pressed bond yields to lows not seen in decades: they shake their heads about the high prices of shares, colossal corporate and household debt, and global deflationary pressures. On the other are the cheerier people who take heart from companies' efforts to reduce their debts and costs, and from the determination of the Federal Reserve (though not, admittedly, the European Central Bank) to do anything necessary to get the economy going. This lot have been declaring the equity bear market over.

As bond yields have revived and share prices have risen in recent weeks, the second camp has been sounding the more confident. Their case was helped by an upbeat assessment of America's economic prospects by Alan Greenspan, the Fed's chairman, on July 15th-even though, funnily enough, stockmarkets slipped after he spoke. But they had been climbing for weeks before then.

In total, share prices have recovered only a little of the ground lost since early 2000 (see chart). Still, since its low point in March, just before the Iraq war, America's Dow Jones Industrial Average has risen by 21%; stockmarkets in Britain, France and Japan have jumped by 25-30%; and Germany's DAX has surged by 54%. In dollar terms 39 of the 40 markets that The Economist tracks in its indicator pages are higher than at the start of the year.

Until the middle of June, bond markets seemed to be sending an opposite message. Fearful of deflation, which raises the value of anything that pays a fixed rate of interest, investors bid bond prices up (and thus yields down). But in the past few weeks, yields on ten-year Japanese government bonds have more than doubled, to just over 1%. Ten-year American Treasury-bond yields have risen by almost a percentage point since mid-June, to close to 4%. Yields jumped by another quarter-point after Mr Greenspan's speech.

By his standards, Mr Greenspan was positively ebullient about America's prospects. Over the past three quarters GDP growth has averaged around 1.5% at an annual rate. But the Fed expects a strong rebound in the second half of this year, followed by growth of 3.75-4.75% in 2004.

Certainly, there is good reason to expect a spurt in growth over the next few months. America's monetary and fiscal policy has never been looser. But will such rapid growth be sustained? "If the past is any guide," said Mr Greenspan, this "should bolster economic activity over coming quarters." Yet the present business cycle is not a normal one. The past must be read carefully. History, not least in Japan, suggests that economies take longer to recover after bubbles: growth tends to remain subdued until the excesses of the bubble years, such as over-borrowing and over-investment, are purged.

Mr Greenspan gave the impression that these excesses have been much reduced, because firms and households have restructured and strengthened their balance sheets. This is optimistic. Although firms have cut costs, their debts have continued to rise. Households have not gone as far in repairing their balance sheets as Mr Greenspan suggests, largely because low interest rates have allowed consumers to keep spending. Many Americans have swapped their old mortgages for new, larger ones at cheaper rates. They have thus continued to build up debt, leaving themselves vulnerable to rising unemployment, or another stockmarket slide, or a fall in house prices.

When long-term interest rates stop falling, mortgage refinancing will slow. If mortgage rates rise, refinancing could slump. This could cut consumer spending, pushing GDP growth back below trend. The importance of mortgage refinancing in supporting spending may explain why Mr Greenspan tried (but failed) to keep the bond market happy by signalling that short-term rates would remain low for as long as it takes to achieve strong growth and ward off deflation. If necessary, he said, rates could be cut below today's 1%.

Record breakers

Andrew Smithers, a London-based economist, says that America's extraordinary number of economic imbalances entitles it to an entry in the "Guinness Book of Records": low personal saving, record levels of household and corporate debt, enormous current-account and budget deficits, and so on. So long as these persist, he thinks, monetary and fiscal reflation will provide only temporary relief.

Mr Greenspan argues that continued rapid productivity growth bodes well for future profits. Yet in a highly competitive market, in which firms have little pricing power, productivity gains are more likely to be passed on to consumers in lower prices. In any case, profits remain weak. Reported operating profits of American firms rose by a healthy 13% in the year to the first quarter; but, as measured (more accurately) in the national accounts, they increased by only 2% over the same period.

Small wonder. Profits depend on nominal GDP growth. Yet America's recovery is its weakest in modern times, and inflation is unusually low. As a result, nominal GDP has grown at an annual rate of less than 4% since output bottomed in the third quarter of 2001, compared with an average 9% rate in the two years after the previous eight recessions ended. Today's forecasts of double-digit profit growth in the next few years look unrealistic.

Recent rosiness about America is perhaps understandable, given how much money has been thrown at the economy. The chart puts the scale of America's monetary and fiscal easing into international context. Britain has also loosened fiscal policy significantly. In Japan fiscal policy has been tightened, while in the euro area, where until now budgets have been constrained by the stability and growth pact, it has been broadly neutral. Real interest rates have also been cut by far more in America (4.3 percentage points) than elsewhere. So it is no surprise that America's economy, though weaker than had been hoped, is expected to grow faster this year and next than either Japan's or the euro area's. Britain is also tipped for stronger growth of around 2.5% next year.

Yet there seems to be no relationship between the size of recent gains in share prices and recent revisions to growth forecasts. American shares have done less well in recent months than those in Japan and Europe (especially Germany). Expectations of growth and profits have held up better in Britain than in the euro area, yet the FTSE 100 has so far recovered by less than most euro-area indices.

The euro-area economies did not grow at all in the first quarter of this year, and may have shrunk in the second. The European Central Bank did not cut interest rates at its meeting on July 10th. Many economists think that growth and inflation will be lower than the ECB expects, implying sluggish growth in nominal GDP and therefore weak profits. Forecasts for GDP growth in Germany, the largest economy in the euro area, have been revised down (to zero this year and 1.2% in 2004, according to the forecasters polled monthly for our indicator pages), yet German share prices have risen roughly twice as fast as other markets since March. This may be because Germany's stockmarket had previously suffered a steeper fall.

In Japan, by contrast, the rally in share prices has been accompanied by much talk that the economy is at last on the mend. This week, the Bank of Japan upgraded its economic outlook for the first time in a year. But it is foreign buying that is driving up share prices. Perhaps locals know better. Although Japan's GDP grew by a robust 2.6% in the year to the first quarter, faster than America, and business confidence seems to be perking up, prices are still falling. So nominal GDP continues to shrink. In the year to the first quarter Japanese firms boosted profits by 12%, by slashing costs. Further big gains will be hard to come by so long as deflation persists, because job cuts will depress demand.

All in all, stockmarkets seem to have got ahead of themselves. Historically, bear markets do not end until shares become truly cheap. According to Mr Smithers, Wall Street needs to fall by a third to reach fair value-or by 60% to look as cheap as at the bottom of previous markets.

Share prices might, of course, rise a bit more in the short term. Funds have been sitting on cash that they must invest somehow, and nobody will want to miss out on a rally for fear of having that money taken away. But to take hold, rallies need support from both profits and cheap valuations. Ten years ago, at a similar remove from the bursting of its stockmarket bubble in 1989, Japanese share prices climbed by 30% in four months, spurred by falling interest rates and a large fiscal stimulus. They are a lot lower now. Smiling investors should take note.

Courtesy of: http://www.economist.com