Hamish McRae: Share prices seem remarkably sanguine if economic trouble is coming our way

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The Independent Online

What are the world's equity markets trying to tell us? It seems bizarre that after the mayhem of the summer – the huge and continuing squeeze on liquidity which has forced losses on most of the large banks and brought a few smaller ones around the world to their knees – share prices should have rebounded back to all-time highs.

Here in Britain, the main indices still have some way to go to pass their previous peaks at the Millennium, but shares here have rather lagged behind other places. New York is very close to its all-time high and Asian shares keep hitting new peaks. Insofar as share prices are supposed to give an early warning signal, albeit an imprecise one, of economic trouble to come, they certainly seem remarkably sanguine. If they are right, maybe Gordon Brown should not worry about going for an early election after all: maybe the economy won't get worse next year.

The flow of international economic news carries similar contrasts. Just this week, we have had more dire news about US housing, with prices going into what commentators describe as "freefall", yet British company profits (which actually reflect global demand as much as British) are rising to a new peak.

We still have a lot of strain evident in the money markets. It is intriguing to see reports that London banks are borrowing heavily in Frankfurt from the European Central Bank, rather than from the Bank of England, because they fear that borrowing in London would place a stigma on them. This seems odd, but it would explain the sudden rise in sterling over the past few days, as these euros would be switched into pounds.

The strain is evident in the US, too. The Federal Reserve has cut its interest rates and that has helped a bit. But the Eurodollar three-month rate, the most important single rate for dollar funding, has come down only to a little below the level it was at throughout the past year. You can see that in the first graph: the action by the Fed has offset the rise caused by the mayhem in the markets but banks still have to pay almost as much for their money as they were doing a year ago. The main beneficiary of lower rates has been the US taxpayer, for rates on the Treasury's super-safe bills have indeed fallen sharply – a telling example of the preferences of investors for quality instruments.

But there are losers too, and here, I think, lies part of the explanation of the recovery in share prices. There is a simple explanation of the way the Fed cut has boosted share markets: it shows that the Fed is sensitive to the needs of the US economy and that it will be supportive of growth. The more complicated explanation is that it has made holding US Treasury bills much less attractive and overseas investors have taken this as a cue to press on with the rebalancing of their assets. Part of that rebalancing is a switch out of dollar assets altogether, hence the continuing downward pressure on the dollar. Another part is a switch into equities generally. But, of course, it is only sensible to switch into equities if you believe that the world economy will carry on growing, because it is that growth that sustains company profits. Yet the world's largest economy, America, is in some trouble. Whether or not Alan Greenspan is right to reckon that there is nearly an even chance of recession there, it is not going to be much of a locomotive for the rest of the world for the next 18 months. So the question then is whether the rest of the world economy can "decouple", that is the buzzword, from its largest constituent part.

I have been looking at some comments from Andrew Milligan, who is head of strategy at Standard Life. His judgement is that, while the obvious risks remain, the business community remains pretty confident (second graph) and that the rise in share prices since 2003 has been driven by solid company profits rather than an asset bubble. He also argues that, although the US is slowing, demand from the rest of the world will be moderate to strong.

Besides, what else should savers do with their money? If you are looking at the world from a British perspective, London remains good value. You can see two different and very simple ways of valuing it in the third graph. One is the standard price/earnings ratio. As you can see, shares are now in the low teens, cheap not just by the standards of the mad boom of the late 1990s but not bad by comparison with the early 1990s and not much above the late 1980s, when it was pretty clear that there would be trouble ahead.

The other valuation is to compare the dividend yield with what can be obtained on index-linked gilts. Here, there is a clear two percentage point advantage, off a little from the peak but much higher than it has been through most of the past 20 years.

That is from a British perspective. Suppose, however, that you are an Asian investor coping with a flood of savings that you have been sticking into low-yielding US Treasury bills and you are now under pressure to increase the return. Your domestic markets have shot up, and that is fine, but you also have to manage an international portfolio. There are all sorts of political barriers: you cannot invest in US defence or energy companies on any significant scale for that will arouse Congressional ire. Global commercial property has some element of a bubble to it and, while there are still some places that may be undervalued, property does not have high yields. You end up thinking that the main global equity markets cannot be too bad a bet at present prices. Indeed, since the emerging markets have risen so much, they are often on higher valuations that the established ones.

Indeed – and this goes for investors with a British perspective too – if the present rumblings about a return to higher inflation prove correct, at least equities give some sort of protection in a way that bonds do not. Dr Greenspan is worried about inflation, even if his very low interest rate policy of between 2002 and 2004 is in part responsible for such concerns. Maybe he is right.

I think the general point here is that the markets have got over the worst of the summer's turmoil. The panic has subsided, even if the full consequences of that bumpy period have yet to emerge. We know the world's central banks will pump in liquidity without limit to calm the markets, as they have to in these situations. We are not through this yet but a sense of perspective has returned. Of course, there is a global downturn ahead. The world economic cycle still exists. It may well be that this upward swing of the cycle will be prolonged by emerging market demand – the BRICs (Brazil, Russia, India, China) will be to this cycle what the internet boom was to the last one. But BRIC demand may limit the extent of the downturn and make it much more benign than the last one. That, at least, seems to the message of the markets right now.