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The Mystery of the Market Commentary 368

One of the more remarkable developments on the financial markets has been the extraordinary rise in equities. It’s even been suggested that it could be developing into another bubble, which in due course is about to burst. What on earth is going on?

Running through some of the possible answers we can start with the fact that equities are even now producing quite a reasonable yield. Yield is something which seems seriously to be going out of fashion. It all starts with the phenomenally low level of bank rate at 0.5 %. It’s historically at a level which has never been seen before. And of course we know why that is. It’s the Central Bank trying to get lending going again. They are desperate about this. Their view is that until lending does respond the economy is just not going to get off the ground. The trouble is that for the banks this amazingly cheap money can be used more profitably in financing deals rather than in lending to Joe Snooks Ltd , round the corner. Quite how this impasse is going to be sorted out is not clear. Meanwhile the rate remains at rock bottom.

The other extraordinary fact is that the Government is currently having no difficulty in selling huge volumes of Government securities, Gilts. They sold 4 billion pounds worth last week and received bids for no less than 10 billion. The yield was just below 4%. So despite all the talk of credit rating agencies threatening to remove the Government’s triple A rating, the professionals are in there helping themselves.

In a sense this just adds to the mystery of the equity market. It might be supposed that if equities have become so fashionable, it might have been at the expense of fixed interest stocks. But, no. Both markets seem to be healthy.

However there is another aspect to equities or common stocks. The private sector has been cutting its coat according to the cloth available. Everywhere the attempt is being made to cut costs. Managers are looking at their margins, they’re trying to earn more out of less. Everywhere they are trimming. At first they were doing this to survive. But bad though circumstances may be, they are no longer actually as dire as was expected a little over a year ago. Unemployment in the UK is up but not by quite as much as expected. The mood has changed slightly in consequence. Cutting costs is still the key but not so much as a matter of survival but rather to gain market share, to turn in better than expected results, and generally fighting the good fight. Moreover some competitors have gone out of business. Given the slightly improved circumstances this is a plus for the businesses still in action. It is becoming clear that the economy is doing better than expected. Customers haven’t totally disappeared. They may have become more canny with their money but they are there. In other words we are achieving a modest level of success. There’s no question of the economy going back to where it was two years ago. Then the mood was very different. We were heavily into excess. The sky was the limit. As we can see now we were riding for a fall. Now we’ve had that fall, we’ve had a nasty shock but we’re coming through it. Although we are emerging from the worst of the collapse we are not going back to those excesses of old but to a more careful, more controlled and more disciplined level. And for the private sector this new phase is turning out to be surprisingly profitable. Managers are now being able to do all kinds of things that they’ve wanted to do for donkeys’ years. Apart from one or two very big names like British Airways which are running into really serious labour problems, the smaller and medium sized companies are managing to get their costs down including the cost of labour. The fact is the unions are nothing like as strong as they were in Callaghan’s day. We can thank Mrs Thatcher for that. Secondly labour knows that there just isn’t the cake available to go round. That’s why there is no real threat of inflation. Workers would rather keep their jobs than lose them by striking. They’re also willing to take temporary cuts if that will help keep their jobs.

So in a way it’s no wonder that the equity market has been so strong. This economic setback has turned out to be good for earnings. The market recognises that and the indices have therefore risen. The question now is how far can this go? Six thousand on the Index is now in sight. Can the market get there? There’s a good chance. This trend isn’t suddenly going to cease. Only if the economic situation suddenly changes will it be time to reassess. Of course that change could occur more or less any time. In much of the world there is a current debate about how the world’s economy will survive the authorities ceasing their support measures. When will the Central Banks start to push rates up? Surely not until there is a much more general feeling of recovery? But imagine if the Central Banks see themselves forced to put up rates. Why would that happen? When, if the apparently insatiable appetites for governments stocks suddenly begin to wane, might not governments have to offer more of a return? It’s that kind of inconvenient scenario which could start to change the current climate. If and when rates do start to climb the equity market could be put under some strain.

But in the meanwhile it has to be good news for investors. It’s at least one part of the mechanism which is returning to life, Moreover it hasn’t had to wait for the banks. They may still be largely paralysed, but the capital markets remain healthy. At least that means that industry, even if it can’t borrow what it wants, has access to relatively prosperous capital markets. Perhaps the time has come when the private sector, which has traditionally relied on a vast seemingly limitless supply of short term bank lending which it then used long term, should now be switching to a bigger reliance on capital markets to supply their needs. It could be one of the basic changes to come out of these very trying times.

Tony Rudd

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