Hamish McRae: Markets' merry Christmas despite triple-dip talk

Economic View: Monetary policy has started to be counterproductive as it has all sorts of negative effects

The markets are moving into the festive season in appropriately festive mood. The FTSE 100 index is within half a percentage point of its yearly high. The pound is within a quarter of a cent of its high against the dollar and decently up on the euro over the year. True, the UK 10-year gilt yield is back to 2 per cent, exactly where it was a year ago, after dipping to 1.5 per cent during the summer, but by long-term standards yields remain exceptionally low.

There are, of course, many commentators who expect a sharp reversal of fortune next year. For example, Andrew Smithers of Smithers & Co has been arguing that sterling is woefully overvalued and that equities are too expensive relative to their long-term averages. Some economists are warning of a "triple dip" to the economy and if there were such an outcome the UK's AAA borrower status would presumably be lost.

If may well be that come the new year these negative sentiments will ride to the fore again, but they do not seem to be having much impact on financial markets. In terms of published GDP, the pessimists of a year ago may turn out to be right – we will have to wait to see by how much the figures are revised – but as a predictor of market movements they have been quite wrong.

So why this general optimism? There are two broad arguments:

One is to accept that the UK economy, along with that of other developed countries, is still in the early stages of recovery. So you would expect uncertainty at this stage, with some things turning out better than one might expect, such as the level of employment or car sales, and some worse, including inflation and those GDP figures.

If you start from there, then any setbacks can be seen in the context of an expansion that will last another six or seven years, maybe longer. There is such a thing as the economic cycle, but the next downturn may not come until the late teens and may be quite mild when it does.

Consequently, if there are three or four more years of flat house prices values will be back to their long-term relationship with incomes. Companies can look forward to several years of overall growth. Employment will continue to grow, and assuming inflation does soon come under better control, living standards can start to rise again.

There are, of course, many things that might go wrong. These include the mismanagement of US fiscal policy, prolonged recession in much of Europe, a spike in energy prices, and so on. But the general outlook is positive, the specifics negative, and it would seem reasonable to assume that eventually the general will come out on top.

That seems to me to be a common-sense approach and there is nothing wrong with that. There is, however, another group of arguments that could explain present market buoyancy and produce a less positive conclusion. They run like this: since the financial crisis, governments and central banks have used war-time financing policies to combat a peace-time crisis. While you can justify such tactics in an emergency, these policies have been carried on for too long. As a result they have not only become less effective, they have also started to have unintended consequences.

So the recovery in house prices and the present strength in equities are more a function of a flood of money with nowhere else to go.

That flood will continue awhile yet and not just here in the UK. The European Central Bank has committed to buying distressed sovereign bonds if that is needed to save the euro. The Federal Reserve looks like adopting an unemployment target of 6.5 per cent, albeit as a temporary measure, before it starts to tighten significantly. There are stories that the Bank of Japan, now the election is over, will be pressured into new ways of combating deflation, a shift that has already led to a sharp rise in Japanese share prices. And here we will in the summer have a new Governor of the Bank of England, who has floated the idea of a move to a money GDP target, rather than just an inflation one. Some see this as a way of justifying an even more expansionary monetary policy.

Seen in this light, the present strength of equities is more a reflection of confidence that central banks will keep on printing money rather than confidence in the solidity of the recovery. Which view is more valid?

My own feeling is that monetary policy has started to be counterproductive as it has all sorts of unintended, negative effects. These include damaging pension funds, denying savers any return and encouraging risky investments in the hunt for yield. As a result, shares are not particularly cheap by historical standards.

You can see the price-earnings ratio of US shares, going right back to 1880, in the top graph – I am taking American data as it is to hand, but the same lessons would apply to UK or European securities. Back in March 2009 they were indeed very cheap, as some of us wrote at the time. Now they are above their adjusted, 120-year average.

On the other hand they are not as absurdly valued as US bonds. The bottom graph shows two ways of looking at the relationship between the returns on bonds and equities. The red line shows the real yield of 10-year bonds, which has now gone negative: interest is below inflation. So they are by just about any standards a dreadful investment. The green line shows the US equity risk premium: the gap between the earnings yield of companies and the real yield on cash. On this basis, shares are very cheap.

Conclusion? It is easy to agree that prime bonds, be they US, UK or German ones, are artificially high – ie, long-term interest rates are artificially low. I think a 30-year bear market in bonds may have begun.

It is hard to agree about share values – but where else do you have some sort of protection against inflation?

Suggested Topics
Start your day with The Independent, sign up for daily news emails
ebooksA special investigation by Andy McSmith
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Ashdown Group: Trainee Consultant - Surrey / South West London

£22000 per annum + pension,bonus,career progression: Ashdown Group: An establi...

Ashdown Group: Trainee Consultant - Surrey/ South West London

£22000 per annum + pension,bonus,career progression: Ashdown Group: An establi...

Recruitment Genius: Client Services Assistant

£18000 - £20000 per annum: Recruitment Genius: A Client Services Assistant is ...

Ashdown Group: Junior Application Support Analyst - Fluent German Speaker

£25000 - £30000 per annum + benefits: Ashdown Group: A global leader operating...

Day In a Page

No postcode? No vote

Floating voters

How living on a houseboat meant I didn't officially 'exist'
Louis Theroux's affable Englishman routine begins to wear thin

By Reason of Insanity

Louis Theroux's affable Englishman routine begins to wear thin
Power dressing is back – but no shoulderpads!

Power dressing is back

But banish all thoughts of Eighties shoulderpads
Spanish stone-age cave paintings 'under threat' after being re-opened to the public

Spanish stone-age cave paintings in Altamira 'under threat'

Caves were re-opened to the public
'I was the bookies’ favourite to be first to leave the Cabinet'

Vince Cable interview

'I was the bookies’ favourite to be first to leave the Cabinet'
Election 2015: How many of the Government's coalition agreement promises have been kept?

Promises, promises

But how many coalition agreement pledges have been kept?
The Gaza fisherman who built his own reef - and was shot dead there by an Israeli gunboat

The death of a Gaza fisherman

He built his own reef, and was fatally shot there by an Israeli gunboat
Saudi Arabia's airstrikes in Yemen are fuelling the Gulf's fire

Saudi airstrikes are fuelling the Gulf's fire

Arab intervention in Yemen risks entrenching Sunni-Shia divide and handing a victory to Isis, says Patrick Cockburn
Zayn Malik's departure from One Direction shows the perils of fame in the age of social media

The only direction Zayn could go

We wince at the anguish of One Direction's fans, but Malik's departure shows the perils of fame in the age of social media
Young Magician of the Year 2015: Meet the schoolgirl from Newcastle who has her heart set on being the competition's first female winner

Spells like teen spirit

A 16-year-old from Newcastle has set her heart on being the first female to win Young Magician of the Year. Jonathan Owen meets her
Jonathan Anderson: If fashion is a cycle, this young man knows just how to ride it

If fashion is a cycle, this young man knows just how to ride it

British designer Jonathan Anderson is putting his stamp on venerable house Loewe
Number plates scheme could provide a licence to offend in the land of the free

Licence to offend in the land of the free

Cash-strapped states have hit on a way of making money out of drivers that may be in collision with the First Amendment, says Rupert Cornwell
From farm to fork: Meet the Cornish fishermen, vegetable-growers and butchers causing a stir in London's top restaurants

From farm to fork in Cornwall

One man is bringing together Cornwall's most accomplished growers, fishermen and butchers with London's best chefs to put the finest, freshest produce on the plates of some of the country’s best restaurants
Robert Parker interview: The world's top wine critic on tasting 10,000 bottles a year, absurd drinking notes and New World wannabes

Robert Parker interview

The world's top wine critic on tasting 10,000 bottles a year, absurd drinking notes and New World wannabes
Don't believe the stereotype - or should you?

Don't believe the stereotype - or should you?

We exaggerate regional traits and turn them into jokes - and those on the receiving end are in on it too, says DJ Taylor