Market recovery is no mere swing of mood; ECONOMIC VIEW
Tuesday 16 May 1995
More impressively, they have sustained that recovery despite a bout of weakness in sterling and in the face of rising interest rates - for there is the prospect of at least one further rise in base rates to come. They have also established this higher ground despite the extreme weakness of the Government.
Is there a bigger message here - a rational response to new information - or are the markets simply going though one of their periodic and quite irrational swings of mood?
Traditionally this phase of the economic cycle is bad for share prices. This is the usual market response to a looming increase in inflation (witness the producer price figures yesterday), and the prospect of somewhat slower growth. The markets usually expect policy to be tightened too slowly and the typical British boom/bust cycle to result. But not this time, despite the hesitancy of the Chancellor in increasing base rates.
The explanation comes in two halves. The first is the now conventional analysis of this recovery. That both monetary and fiscal tightening have taken place sufficiently early in the cycle to head off the rise in inflation and to divert resources into exports. So, unusually, the current account has improved though the expansion, rather than deteriorated. And equally unusually, the rise in cost pressures has been quite muted. There are worries, to be sure, but the order of magnitude of those worries is vastly smaller than in previous cycles. Seen in the big, the prospect is for a shift from very rapid growth to a more sustainable expansion without a catastrophe on the way - the "soft landing" which the markets are also seeking in the US.
The second part of the explanation is more particular to the performance of British corporate sector. Two things are happening. Profits and dividends are coming in slightly higher than the consensus expected even six months ago and there is a spate of take-over activity, which while modest by mid-1980s standards, has encouraged brokers to round up the usual suspects for future bids.
Profits for the British corporate sector look like being 14 per cent up this year and current projections are for another 10 per cent rise in 1996. This will underpin last year's rise in dividends. The improved dividend performance has helped push the dividend yield close to its 4.5 per cent long-term trend. As the graph shows. If one looks at the prospective dividend yield for the next 12 months, on present projections the yield would be around 4.7 per cent, which would suggest that, while not actually cheap, British equities are very fairly priced at present levels. Against bonds (as the other graph shows) there are already quite cheap.
To take yet another measure, the prospective price/earnings ratio for the FT 500 index is down to a little over 12, only a whisker above its ten-year average of 11.6.
The renewed take-over activity has two main effects. It throws a comfort blanket to investors, by showing not just that there are potential bidders around who might be interested in other stocks but that the present price levels are supported by the tough-minded calculations which a bidding company naturally makes.
Quite apart from this, big bids have the further practical effect of putting some new money into the market. Cash bids are the opposite of rights issues, releasing funds from the balance sheets of cash-rich companies. Of course in many bids the cash element is small, but the experience of the Glaxo bid for Wellcome, where a significant part of the £6bn cash proceeds were reinvested in the market, gave the market a new set of numbers to ponder. Not only are there more bids on the way; some of these will inject yet more funds into the market.
All this is comforting. What's ahead?
Let's assume first that the recovery of the bond market has some months to run. To say that, is not to suggest that we will quickly return to the yields of early last year, for the peak of the next bond market cycle is some way off. It is simply to say that current yields of around 8.4 per cent give an adequate compensation for inflation which is unlikely to peak above 4 per cent this cycle.
Any further recovery in bonds will make equities look even cheaper on that measure.
Next, let's assume that there is only one more rise in US interest rates, and that by the autumn the consensus will be that the next movement in rates will be down rather than up. That would be consistent with a turn in the UK interest-rate cycle in the first half of next year - say one more rise in the next few weeks, and maybe a second around the turn of the year. Once the markets appreciate that a turning point is in sight - something they should begin to feel by the autumn - they will be prepared to see equities move ahead again.
Next, let's assume continued take-over activity right through the summer, with a fair proportion of the bids coming from overseas corporations. This will continue to inject new money into the British market.
Finally let's assume some modest new portfolio investment from abroad, as it becomes clear that sterling is undervalued and that there is little danger of a boom/bust cycle.
Put all these together and it is really quite difficult to see circumstances where there would be a sharp fall in the market . The principal contender there would be the long-predicted turn in the US market. Aside from that, then the present UK market recovery begins to look very solid indeed - much more the rational response, than the mere swing of mood.
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