What is risk? Let's start with a question. Suppose 15 years ago you had perfect foresight and knew that the world economy was going to have the strongest period of growth that it would ever experience and that company profits as a percentage of GDP would rise to unprecedented levels. With that knowledge, what would you expect to happen to share prices?
You could be forgiven for expecting shares to soar. But as it happens, share prices in major markets have gone nowhere. Shares boomed a couple of times in between, but the ground gained was in both cases eventually lost. By contrast, if you knew five years ago that the British fiscal deficit would rise to 12 per cent of GDP and that the Government's fiscal rules would be abandoned, you might imagine that gilt prices would plunge. They have soared.
Apply that now. Investors are cautious about the recent recovery in share prices and, following the surge from early March to about a week ago, shares have slipped back a little. At the moment, two divergent views explain this. The more common says that this has been a classic bear market rally, where shares recover only to fall back again, or at least the start of another long period where prices go nowhere. The minority view is that this has been the start of the next bull market and though there will be setbacks, shares in, say, five years time will be back past the previous peaks.
Let's take the minority view (which I agree with) and test it against the probability that this economic recovery will be lack-lustre, as Mervyn King warned last week. If companies find it hard to raise profits in a slow recovery, how could that be consistent with strong share prices?
There are at least half a dozen responses to that. The first is that we are stating from such a low base that we don't need a strong recovery to support prices at these levels; any sort of recovery will do. What seems to be happening now is that the US is close to bottoming out this quarter, though the growth ahead will be muted until households can work off some of their debts. Here in the UK we can see some encouraging signs, particularly in the housing market, though the recovery is unlikely to be evident until later this year.
On the Continent and in Japan the recovery may be later still. Germany had really dreadful first-quarter numbers last week, with its economy now down 6.7 per cent year-on-year. A lot of that is stock adjustment, rather than a fall in final demand, but it is still chilling. While the Bank of England still expects this downturn to be less serious for the UK than that of the early 1990s, Germany's will be the worst since the immediate post-Second World War period. But Germany will be well-placed to take advantage of the eventual recovery.
The second point leads on from that. China and India are still growing, with China seeking to replace lost international demand with a massive domestic stimulus, particularly on investment infrastructure. It is, for example, putting in a nationwide 3G telephone network. Goldman Sachs, which has put a lot of resources into understanding the Chinese take-off and its implications for the rest of us, remains bullish in light of the boost the authorities there are giving to growth. I suppose you could say that cash-rich economies benefit during the downturn, just as cash-rich companies and investors do. China and India will ensure that the world economy has some growth, even if the developed world stagnates.
The next response is that a lot of the yield from the stock market comes from dividends and when you consider that the returns on bonds and cash are minimal, any company paying a reasonably secure dividend is worth holding simply for income. That changes the relative risk profile – holding an asset that produces near zero return has an opportunity cost when other assets, such as equities, do produce some income.
Response number four takes this further. At the moment government securities from major countries, such as the US and Germany, are perceived as very low risk, despite the massive supply of stock that is going to hit the market over the next couple of years. That will surely change. On Thursday, Barack Obama said that the current US deficit spending was unsustainable.
"We can't keep on just borrowing from China or borrowing from other countries," the President said. "We have to pay interest on that debt and that means that we're mortgaging our children's futures with more and more debt .... What's also true is at some point they're just going to get tired of buying our debt and when that happens, we will really have to raise interest rates to be able to borrow and that will raise interest rates for everybody."
That makes sense. When will the turn in long bond yields be? Probably not for a while yet, because historically government bond markets have turned about the same time as unemployment and that will probably continue upwards until some time next year. But the President well articulates the danger.
Response five is that companies are forced by the downturn to improve efficiency. It is a hard and unpleasant truth but you can see what is happening to the US motor industry or indeed British Telecom here in the UK. So when growth returns, even a muted recovery will enable companies to return to reasonable profitability.
And finally, some share prices have been so low – those of the banks for example – that the fact that they will survive at all justifies an investment. Take Royal Bank of Scotland. The price dipped to 10p in January; now it is close to 40p, terrible when set against the 650p back in August 2007 but a four-fold increase none the less.
Look: be careful. I am not saying the recovery is secure, because it isn't. I am not saying that growth next year will be great because in all probability it won't. I am really frightened by the scale of the debts that our Government has taken on, not just as a result of this downturn but as a result of a failure to match revenue to spending over the previous seven years. As for the US, the dangers described by Mr Obama seem very real. Interest rates will be higher worldwide and the huge public borrowing will crowd out private-sector borrowers. The danger is that these higher rates will come through before the recovery is secure.
Amid these reasons for concern, I take comfort from the fact that two years ago, when everything was riding high, a lot of us felt a sense of unease about the future. That unease proved justified, and how. But now the mood of fear is the counterpoint to the complacency then. Two years from now, things will feel very different: not great but an awful lot better.
The good news? Average house prices will hit bottom in 2012 at £130,000
Beware the supposed "green shoots" in the housing market. A number of estate agents are now reporting more interest from buyers and the odd price increases are coming through. But according to the futures market, prices will not bottom until 2012.
As a general rule it is better to look at how the market prices things rather than what interested individuals say about trends. But the interdealer brokers, Tradition, derive forward house prices from the futures market and you can see what the market thinks the average UK house price will be at various dates in the future. At the moment, the average house price according to the Halifax index is just over £157,000. According to the futures market the average price a year from now will be £137,000, and it will fall further to £130,000 in 2012 before starting a gradual recovery.
If that sounds glum, it is actually mildly encouraging – at least for sellers if less so for buyers. A month earlier, the index was suggesting a price of only £127,000 in a year's time, falling to £125,000 in 2012. So there has been a marked recovery of confidence in just four weeks.
What should we make of this? Like all markets, this index is just reflecting people's views about the future and like all markets it is quite volatile. The basic message is that we should not expect any significant recovery in prices for another couple of years but that the declines will lessen and most of the fall will be through in a year's time. The timing of the recovery has not changed over the past few weeks but the assessment of the depth of the slump has. Instead of house prices bottoming out some 20 per cent below present levels, the futures market is now suggesting a further fall of 12 to 15 per cent.
That would make sense. Funds for home loans are coming through a little better but it is not reasonable to expect prices to move up much until a turn has taken place in unemployment and people feel more confident generally. That might happen by 2011 but it is not realistic to expect it much sooner.Reuse content