THE POWER OF FAITH / THE ECONOMIST ( A MUST READ )

Buttonwood
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The power of faith
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Equity markets are rallying again on hopes of central-bank action
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Aug 11th 2012

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IF A couple of trading days could sum up the mood of financial markets this year, it has to be August 2nd and 3rd. First, equities plunged in reaction to the latest statement from the European Central Bank (ECB): investors were disappointed that it had not announced an immediate wave of bond-buying. Then markets rallied just as strongly the next day as they reflected on the ECB’s statement (see article); crucially, the yields on Spanish government bonds fell back.

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It has been a switchback year all the way through. The volatility also illustrated how dependent financial markets are on the actions of central banks. Fiscal policy is generally being tightened in the developed world, whether voluntarily (as in Britain) or under pressure from creditors (as in southern Europe).



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But there is still scope for monetary easing in the form of bond-buying programmes, financed with newly created money. So investors wait agog for every central-bank announcement, every publication of the latest meeting minutes, every speech by a board member.

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Although the markets have often been disappointed by European rescue plans, hope springs eternal that the ECB and the politicians will come up with some kind of package that will prevent a break-up of the single currency and stop the continent’s slide into deep recession. When hopes of such a deal rise, investors can be indiscriminate about which assets they buy. In July, European shares, ten-year German Bunds and gold all rose by more than 2.5%. According to Dhaval Joshi of BCA Research, it was the first month in 400 that all three had risen by so much.




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The latest rally occurred despite some dismal European economic data and a steady downgrade of profit forecasts. The latest batch of bad news included a 0.7% fall in Italian GDP during the second quarter, and very weak manufacturing surveys in France and Germany. The Bank of England is now not expecting the British economy to grow at all this year.




The American economy is still growing, at least, although the recovery is hardly robust. Developing countries are generally set to post lower GDP growth than they did in 2011. All this has caused profit growth at S&P 500 companies to slow from an annual rate of 29.2% in the fourth quarter of 2011 to just 6.6% in the second quarter of this year, according to Société Générale.





As ever, analysts are optimistic that this slowdown will be temporary. The annual profits-growth rate of S&P 500 companies is expected to be back in double digits by the fourth quarter.



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Globally, profits growth of 13.5% is predicted for 2013 after 7.5% this year. But this anticipated rebound is pretty hard to square with the latest economic data. It would probably require further increases in margins from levels that are already, in America, close to 50-year highs.



Wall Street is priced as if these margins can be maintained. The cyclically-adjusted price-earnings ratio (which smooths profits over ten years) is still 21.4, well above the historical average, according to Robert Shiller of Yale University. Euro-zone shares look a lot cheaper—their cyclically-adjusted p/e ratio is 11.5, according to Absolute Strategy Research, a consultancy. But the risks appear to be much greater.





Where could a boost to growth come from? Earlier this year, lower energy prices seemed to offer some prospect of relief: a fall in the petrol price is the equivalent of a tax cut for Western consumers.




But Brent crude has rebounded very sharply in recent weeks (see chart), from $90 to almost $110 a barrel, in part because of fears that the Syrian conflict will spread across the Middle East. Developing countries do have scope to ease monetary policy and boost growth. Central banks in the Philippines, South Korea and Vietnam all cut interest rates in July.



But the main argument for owning equities is the unappealing nature of the alternatives. The return on cash is close to zero in most of the developed world. In terms of developed-country government bonds, investors have the choice of yields below 2% in America, Britain, Germany and Japan, or a plunge into the riskier markets of southern Europe. Emerging-market debt enjoys much better credit ratings these days but here too yields are often very low: Brazil’s dollar-denominated ten-year bonds yield just 2.3%.




Contrast that with the 3.7% dividend yield on London’s FTSE 100 index, or with the 3.4% yield available on German shares, and the temptation to switch some money into equities is understandable. Any good news is likely to prompt a rally. Investors just have to hope that central banks really can rescue their economies with the tools they have available.