Since the beginning of the year developed markets have outperformed emerging markets primarily due to more direct exposure to easing, as well as some short term concerns over growth. Figure 4 shows the effect of Japan’s new monetary regime1 on the Nikkei, which has posted a return of 27% (or around 13% in dollar adjusted terms) since the start of January.
A much more mixed picture appears for emerging markets, but this has more to do with the inherently volatile nature of emerging market equities than with unhealthy fundamentals.
Underpinning these gains are the major central banks, who continue to inject massive amounts of liquidity into the global financial system (see Figure 5). Since early 2009, when the Federal Reserve (Fed) and Bank of England (BoE) first launched quantitative easing, markets have seen gains of around 40%.
As yields on safer assets have been severely compressed, equity markets have benefitted from investors looking to achieve real returns on their investments. For example, the FTSE 100 currently offers a dividend yield of 3.5%, compared to a 1.8% yield on gilts and a projected inflation rate of 2.8%.
Despite strong gains, markets do not appear overpriced. The FTSE 100 trades on a forward P/E (a measure of how expensive a company is) ratio of 13.9, slightly below its 10-year average of 14.3, and other developed markets (e.g. S&P 500) offer attractive dividend yields at below average valuations.
Reassured by central bank action, investor sentiment seems to be improving. With volatility at a five year low (Figure 6), investors are increasingly willing to take on risk. Given that growth forecasts remain subdued, this has been a key factor in driving returns so far.
For the time being, this easy monetary stance is here to stay. The BoE and Fed are shifting their focus more towards growth than inflation targeting, and most central banks have explicitly committed support until economic conditions have markedly improved.
There are benefits to this stance, but risks remain. Good quality corporates are in a strong position. With strong cash flows and cheap access to finance, the resources are there to increase earnings. On the other hand, continued loose monetary conditions enables 'zombie' firms to survive, hoarding capital that could be more effectively deployed elsewhere, so delaying the economic recovery.
Although there has been no clear effect yet, concerns around inflation persist. Households are most at risk from rising prices, which have depressed real wages in many countries in recent years, notably the UK.
Are there signs that companies are returning to profitability? In the US, which is still the largest and most important economy in the world, the earnings season (when companies report Q1 performance) has been gently encouraging so far.
Global banks have generally reported rising profits, beating estimates and indicating that the financial system continues to heal, which is a prerequisite for a sustained economic recovery. Meanwhile, other broader economic 'bellwether' firms have struggled to grow, indicating that a recovery in the wider economy is yet to take hold.
Stock markets are often held to be leading indicators of the economy, so while rising equity markets may look strange against a backdrop of sluggish economic growth, they could be indicating expectations of better conditions to come.
In our recent paper 'What stock markets can tell us about the real economy'2, we assessed how well UK and US stock markets predicted future economic growth over the past 40 years. Our results,as summarised below, indicate that forecasting ability is weak for the UK, but better for the US. Even then, the predictive power of the US market only extended to a short 1 quarter horizon, hardly sufficient for business planning purposes. So signals from stock markets need to be treated with some caution.
|Table 1– The stock market is not always a good leading indicator|
|Strength of stock market price effect||Moderate / weak||Weak||Strong||Strong|
|Price effect lag time||3 quarters||1 year||1 quarter||1 quarter|
1. For more analysis of the importance of Japan’s new monetary policy regime, please see our previous April issue of the Global Economy Watch.
2. For the full paper please see: www.pwc.co.uk/the-economy/publications/stock-markets-and-the-real-economy or our 'Economics in Business' blog