Equity markets are looking decidedly sick. The bellwether US S&P 500 index has dropped from around 2,100 in early August to below 1,900. The FTSE 100, which was above 7,000 as recently as April, is down to 5,900. Ouch.
One proximate cause of this market mayhem is China – its economy is slowing down and its currency, the renminbi, suffered a mysterious wobble in mid-August. Another is a growing fear of higher interest rates. The Federal Reserve may have kept its powder dry in September – thanks, in part, to the Middle Kingdom’s tremors – but Janet Yellen and her colleagues have given plenty of hints that they intend to tighten monetary policy by the end of the year. In the UK, meanwhile, a pick-up in wage growth has fuelled expectations that the Bank of England may be thinking more seriously about raising interest rates.
There are also, however, some more “structural” worries. Ever since the global financial crisis, the pace of economic expansion has been disappointing both relative to history and to the expectations of the majority of economic forecasters. And what was originally thought to be primarily a problem for the industrialised world has now spread to the emerging world. China’s slowdown has hit the commodity-producing economies of Latin America hard. Brazil is in recession. Many emerging market currencies have collapsed.
At the same time – and with the occasional emerging world exception – inflation has been persistently too low. For all the stimulus in China and for all the quantitative easing in the West, central bankers are still fretting more about the consequences of deflation rather than excessive inflation – so much so that Andy Haldane, the Bank of England’s chief economist and its resident “big thinker”, recently suggested that notes and coin should be abolished to allow the imposition of so-called “negative interest rates”.
True, central bankers are constantly telling us that inflation will soon return to target – 2 per cent being the magic number for most of the major economies. And they typically take the view that recent declines in inflation are mostly for temporary reasons: lower oil prices, falling commodity prices, a stronger than expected exchange rate.
But, to paraphrase a Mandy Rice-Davies misquote, “They would say that, wouldn’t they?” Central bankers will always forecast a return to target, because anything else would reek of failure. Inflation has been lower than expected whether currencies have strengthened (the US, the UK) or weakened (the eurozone and Japan). And it may just be that lower oil and other commodity prices are less a windfall gain for Western consumers and more a signal that deflationary pressures worldwide have simply intensified.
Why might all of this be problematic for equity investors? Go back far enough in history and a simple “rule of thumb” governed investment decisions in difficult times. In a world of low growth and high inflation, you outperformed by investing in so-called “real” assets directly linked to economic activity rather than in “nominal” assets. Back in the 1970s, for example, investors in the US and Europe were better off putting their money into equities and property, which were directly linked to economic growth, than in government bonds – which suffered thanks to higher-than-expected inflation.
Conversely, in a world of low growth and either actual or threatened deflation – the world Japan has occupied since the early 1990s – you were better off avoiding real assets and putting your savings in nominal assets.
This rule of thumb, however, sits uneasily with financial market experience since the global financial crisis, a period during which growth has been mostly lower than expected and central banks have been battling with deflation, not inflation. The rule of thumb would have suggested investing in government debt, not equities. Yet between the beginning of 2009 and May of this year, the total return on US government debt – a useful 24 per cent – was eclipsed by a 171 per cent gain on the S&P 500.
One reason why equities did so well was, of course, that they’d done so badly during the financial crisis. But it wasn’t the only reason. In the US, the profit share within the economy rose rapidly largely because companies were able to squeeze wages. Quantitative easing, meanwhile, was explicitly designed to encourage long-term investors to switch out of low-yielding government debt into equities and other “riskier” financial assets. The hope was that capital market strength would enable companies to invest without having to rely on lending from a shrinking banking system.
QE, however, has not quite delivered the goods. It certainly helped prevent a repeat of the 1930s Great Depression – where, in the US, output collapsed – but we have yet to see a return to the growth and inflation conditions prevailing before the global financial crisis. Investment is weak, productivity growth is disappointing, world trade is shrinking and, because interest rates are more or less at zero, there is little that conventional monetary policy could now do in the event of another negative economic shock.
Put another way, perhaps equity investors are recognising that stock markets only tend to do well in circumstances where growth is great or where protection against the perils of inflation is paramount. Monetary support on its own – whether of the conventional or unconventional type – is not good enough to defy gravity on a permanent basis. Investors may still be hoping that US companies will be able to squeeze out some more profits growth in the years ahead but a story based on a rising profit share alone must necessarily be finite.
China may be tricky and the Fed may be increasingly trigger-happy, but these are only the proximate causes of investor unease. The foundations have been shaky for a long time: China and the Fed have simply exposed a problem that was already there.
Stephen King is HSBC’s senior economic adviser and author of ‘When the Money Runs Out’