So, Papa Ben is going to keep the Calpol flowing for a while yet.
Our last update drew the parallels between the market’s fear of QE tapering, and the child who demands Calpol at regular intervals because he or she sees it being synonymous with “being better”.
Well, it is still going to be dispensed regularly for the foreseeable future, and the market loves it! Bond yields have plummeted and equity prices have soared; and all because we are not healthy enough to have our medicine stopped just yet.
There is an undeniable logic to some of this. Fed Chairman Ben Bernanke clearly did not anticipate that his comments earlier in the summer would lead to such a spike in US long term interest rates. The impact on the US housing market was almost immediate; so it was right that the Fed should look to correct this unintentional “policy error”.
However, unbridled euphoria is not the correct response to last night’s information. Rather circumspection. The Fed has managed to bring down longer term interest rates a touch, and has emphasised that tapering of QE really is dependent on stronger economic data. And markets have in turn pushed US equity markets to new highs and other global markets (including ours) are getting close to multi year highs reached in May. But markets can only do so much by themselves. Markets can only push on the valuations on businesses so far before the fundamental drivers of that value (namely profits) have to catch up to justify higher share prices.
We may well have “called markets right” over the last couple of years. The danger is that we allow those gains to condition our thinking about what truly drives investment returns – that as long as monetary policy remains exceptionally loose, asset prices will carry on up regardless. Buying into that strategy is a very dangerous game of chicken. We have no greater idea than anyone else about when the QE gravy train is going to stop. But stop it will. And when that time comes we need to be holding a portfolio of equities that can justify their valuation in more normal monetary conditions.
We have stressed this many times before, but the future really is about companies, and not markets. Markets have done pretty much all they can by themselves. Based on our long term analysis of UK equity valuations, the UK market is no longer what we would regard as “cheap” based on its historic earnings. That does not mean it is expensive – it means that future returns need expectations of corporate profitability to improve; something that has been conspicuously absent in the last 18 months.
In the UK and the US, authorities have succeeded in getting consumers to spend more on their housing and slightly more on big ticket investments like new cars. But wage pressures in both of these economies mean that this pool of potential spending is limited in size. We know governments generally can’t spend any more. We also know that companies do have the capacity to spend, but despite record low interest rates they have been reluctant to do so. Will shaving another 0.5% off long term interest rates really change that dynamic?
There are multiple other sources for profit growth, beyond that driven by consumer or government expenditure. Internal cost reductions, investments in new technology, accessing new markets with new or better products, cost reductions after mergers or acquisitions, price increases in strong market positions. There is a lot that can happen to drive profits up, but it is not going to happen across the board.
We’ve talked a lot about markets – we need to talk more about companies.