Equity markets have been rising on modest volumes. There has been too much liquidity chasing too few shares, despite the substantial new issues from undercapitalised businesses. The quantitative easing money from both sides of the Atlantic has been moving into riskier assets. Portfolio investors are less nervous about the future than they were at the height of the credit crunch crisis last year, or near the bottom of the panic about the real economy in March of this year.
The upward movement in shares has been common to most markets, though Asian and emerging market equity as we hoped has done better. This reflects the light exposure most US and UK funds have to these parts of the world, and the sudden need to have more representation, as well as the bullish speculation in markets like China and India where domestic liquidity has helped fuel the share booms. It also underscores the reality, that these parts of the world should grow much faster than the west in the next few years. Equity investment in the end is about growth in dividends and asset values, so it makes sense for equity investors to seek out the faster growing prospects.
The US and UK economies will turn round on the back of the large official interest rate declines, the quantitative easing, and the end of the violent de-stocking phase of the downturn. They will, however, be constrained in their future growth by the need to shift more resources into reducing the trade deficits and more importantly into paying back debt and reducing leverage throughout the public and private sectors.
The US and UK governments have both decided to cushion the contraction and delay the adjustments they need to make by printing money and by running very large public sector deficits. At some point they will have to stop quantitative easing. At the same time markets may decide they want a higher rate of interest in order to lend money to these governments, triggering slower growth and more tensions within the economy.
Commentators and some investors have justified the sharp appreciation in many share prices in three ways. They correctly point out that at the market low investors had many apprehensions about the collapse of the system, fears which now seem to be overdone. They argue that recent profits figures have been better than expected, with signs of revival in the banks and commodity linked companies as well as general trading companies. Careful analysis shows that in many cases the better earnings are the result of quick and drastic action taken to cut costs, rather than of growth in revenues and business, whilst the clearing banks are still reporting more write-offs and distress in their loan books. They go on to suggest that there will be a reasonable recovery from here. It does seem likely that the rate of decline will slow, and that the US and UK will respond to the huge monetary stimuli administered. It is also likely that there will be problems ahead, weaning these economies off these very large monetary injections.
The dollar went through a sharp fall, but has rallied somewhat against sterling in the last couple of days. Both currencies are likely to weaken against the Asian currencies in the years ahead. US and UK government bond yields have risen from their lows. We still suggest avoiding them, as the full impact of their large issue programmes strikes home. High grade sterling corporate bonds have risen somewhat in the last couple of weeks, but we still recommend holding them as the yield differential between these bonds and gilts remains substantial.