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Busily going nowhere

Buttonwood

Low interest rates have been a mixed blessing for equities

Sep 23rd 2010

IF YOU are the sort of person who does not pay much attention to the daily

gyrations of the stockmarket, congratulations. After nearly nine months of

volatility, and a deciduous forest s worth of reports by stockbrokers on the

outlook for markets, global share prices are back where they were at the start

of the year.

All this frenetic activity has doubtless generated lots of income for middlemen

in the financial sector. But the clients of stockbrokers have, in aggregate,

merely taken home their dividends. And given that the American market is

yielding just 2.5%, a lot of that will have been absorbed by fees and

commissions.

The lacklustre performance of equity markets in 2010 is symptomatic of the

previous decade. A long-term asset-return study by Deutsche Bank found that

American equities had delivered slightly negative returns over the ten years up

to the end of July.

The factor pulling stockmarkets in different directions this year has been low

interest rates. On the one hand, low rates entice investors out of cash and

into riskier assets. For example, issuance of American high-yield (or junk)

bonds has already reached $168 billion this year, more than was raised in the

whole of 2009. Jim Sullivan of Prudential, an American insurance group, says

that many institutional investors are drifting up the yield curve, buying

investment-grade bonds as an alternative to low-yielding Treasury bonds.

Equities have benefited from the same process.

On the other hand, the implication of low interest rates is that the outlook

for economic growth, and thus corporate profits, is extremely subdued. The

market has suffered a couple of growth scares this year, first when the

European sovereign-debt crisis was raging in the spring and second, in August,

when there was talk of a double-dip recession.

The markets have snapped out of their funk this month. There have been some

moderately better data from America on non-farm payrolls and manufacturing

activity. The National Bureau of Economic Research said this week that the

American recession ended in the summer of 2009.

But the data have been far from universally upbeat. The real boost to

confidence may have come from the conviction that the central banks will act

again to revive activity. These hopes will have been encouraged by the Federal

Reserve s latest statement on September 21st which talked, unusually for a

central bank, of inflation levels below those the committee judges most

consistent over the longer run with its mandate to promote maximum employment

and price stability. In short, inflation is too low.

With rates already near zero the Fed s remaining policy option is to pursue

quantitative easing (QE) in the form of money creation to buy government and

corporate bonds. But will that do much to help the American economy? Paul

Ashworth of Capital Economics points out that when the Fed stopped its first

round of QE Treasury-bond yields were around the same as when it started.

Indeed, yields have fallen since the Fed stopped the programme. And Capital

Economics measure of broad-money supply (M3) fell while QE was in operation.

David Bowers of Absolute Strategy Research nonetheless argues that low rates in

the developed world will eventually boost global growth as they are imported by

the developing world via managed exchange rates. Asia will come to the rescue

of America and Europe. Perhaps. But there are complicating factors, including

the potential for international disputes as Asian countries try to manage their

exchange rates (see article).

There is also the danger of complacency. Japanese stagnation couldn t happen

here, Western commentators used to argue, because the Japanese were too slow to

act, propped up their problem banks, tightened fiscal policy too early and all

the rest. Yet history is repeating itself.

Core inflation in America is less than 1%. Two years after the Fed slashed

rates almost to zero, ten-year Treasury-bond yields are 2-3%, around the same

level as Japanese bonds reached two years after Japan s short-term rates fell

to 0.5%. European governments are tightening fiscal policy well before their

economies have recovered output lost in the recession.

The more the economic outlook turns Japanese, the harder it will be for equity

markets. American equities may have had a decade of poor returns since the

dotcom crash in 2000. Yet Japanese investors have had to endure two decades of

frustration (and counting) since the end of Tokyo s bull market.