The rally in financial markets

Liquid fuel

Investors are betting on a vibrant recovery. With returns on cash so low, they have little choice

“EXTRAORDINARY how potent cheap music is,” the playwright Noel Coward declared. He could have said the same about cheap money. With cash on deposit yielding not much more than zero in many rich countries, there has been a powerful rally in most financial markets. In America, money-market funds yield around 0.1% after fees, so an investor with $100,000 receives just $100 in annual interest. Unsurprisingly, investors have withdrawn $332 billion from such funds this year, or around 10% of total assets, according to EPFR Global, a data provider.

Investors elsewhere also seem to be putting their cash to work. The MSCI world index of global share prices is up by almost 24% so far this year, having fallen by a similar amount between January 1st and March 6th. In the debt markets, the spread (or excess interest rate over Treasury bonds) on high-yield corporate bonds has fallen from more than 16 percentage points at the start of the year to around seven and a half points now (see chart). Commodities have not missed out—gold has moved back above $1,000 an ounce.

The markets are enjoying a “sweet spot” in which economic and profit forecasts are being revised higher but the outlook for interest rates (and thus borrowing costs) remains on hold, thanks to subdued inflation. On September 23rd the Federal Reserve said that the American economy had “picked up” but that interest rates were set to remain “exceptionally low”. The data indicate that most developed economies have emerged from recession. The second-quarter profits of S&P 500 companies may have dropped by nearly 30% year-on-year but they were still an improvement on the first quarter. Analysts forecast a 28.7% increase in global corporate earnings in 2010.

What is true for the developed world is true in spades for emerging markets. Emerging stockmarkets are up by a remarkable 62% since the start of the year and are 94% above their lows. Mark Mobius, an emerging-markets investor at Franklin Templeton, thinks that analysts are underestimating the potential for recovery and that many markets can surpass 2007 highs.

Indeed, there is already talk that emerging markets could be the next bubble to be inflated by loose monetary policies. Investors perceive developing countries to have much better growth prospects than those in the developed world. Liquidity is fuelling the Chinese market in particular. According to Dylan Grice of Société Générale: “[Chinese] banks which haven’t wanted to lend have lent to borrowers who didn’t want to borrow…the money is now flowing into the stockmarket, into commodity inventories and into property.”

But bubble talk seems a little premature. Markets have rallied very fast, but they fell just as quickly in the six months to March. It is worth remembering that even if the Dow Jones Industrial Average regains the 10,000 level in the near future, it will still be more than 4,000 points below its all-time high, recorded in October 2007. The MSCI world index is around 32% below its peak. Some of this rally is down to sheer relief that the market is out of crisis mode (the cost of borrowing in the money markets is back to near-normal levels, for example).

The more difficult question to answer is whether the surge is the start of a long-term bull market or simply yet another bear-market rally, like those Japan enjoyed in the 1990s. The deleveraging that many have long predicted has not really started; government debt has simply substituted for private-sector debt. So the economy may be very reliant on action by central banks and governments and may slump once that support is taken away.

Some forms of stimulus are already being withdrawn. The American “cash-for-clunkers” subsidy for car sales ended in August. Edmunds.com, a website, predicts that the annualised rate of car sales in September will be 8.8m units, down from more than 14m in August. The fear is of a “Weekend at Bernie’s” recovery, after the 1989 film, in which two office workers pretend their dead boss is alive (putting sunglasses on the corpse and propping it up) so they can enjoy the party lifestyle.

Equity and corporate-bond markets have also been boosted by quantitative easing (QE), the process whereby central banks create money to purchase (mostly government) bonds. That has helped keep the lid on Treasury-bond yields. In June the ten-year bond yielded almost 4%; it is currently around 3.5%, pretty low by historical standards even though governments are issuing record amounts of debt. The fear is that if QE stops, yields may rise sharply, driving up borrowing costs for everyone. “At some point the quantitative easing will come to an end but until it does this bull market is sponsored by [governments] and everyone should enjoy it,” Crispin Odey, a hedge-fund manager based in London, recently urged his clients.

Yet the stockmarket seems to assume a robust economic recovery. The S&P 500 index is trading on a price-earnings ratio of around 20, based on 2009 forecasts for operating earnings. A more cautious approach, using earnings reported under official accounting standards, puts the multiple at 27. Both numbers are well above the historical average. According to Smithers & Co, the American market is 37% overvalued on the best long-term measure, the cyclically-adjusted price-earnings ratio (which averages profits over ten years).

As a result, the markets look vulnerable to a setback. As strategists at UBS remarked in a recent research note: “Liquidity has been a much bigger driver of this market than fundamentals. Liquidity-driven rallies have a habit of reversing violently without warning.”