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Investing - Equities: the only game in town

2016-07-14 08:22:03

Jul 13th 2016, 15:52 by Buttonwood

WHAT explains the recent highs in the American stockmarket? One explanation is

that the markets were nervous over the British referendum on the EU; before the

vote, it was cited as the biggest risk in the markets by 30% of fund managers

in a Bank of America poll. After the vote, however, investors seem to have

concluded it is mainly a UK and EU issue; indeed even in the latter, it does

not yet seem to be inspiring other countries to depart. So investors who were

sitting on the sidelines have piled back into equities.

However, the Brexit vote did drive government bond yields lower, pushing those

in Germany and Switzerland even further into negative territory. And it seems

likely to inspire a rate cut in Britain and may cause the Federal Reserve to

hold fire on further rate rises for a bit longer. In other words, the returns

in cash and bonds are pretty dismal.

In the circumstances, equities look like the only game in town. so the outlook

would have to be absolutely dreadful for investors to avoid them. And it's not

dreadful. The Atlanta Fed thinks that US GDP grew at an annualised 2.3% in the

second quarter; after a weak May, the non-farm payroll numbers in June were

strong.

The results season for the second quarter is just starting. Forecasts are for

an annual decline in earnings per share of 5%. That's not great. But BNP

Paribas points out that, on a quarterly basis, earnings will be higher than in

the first three months of the year. The impact of the oil price collapse and

the dollar's rise on corporate profits may be fading. In valuation terms, the

cyclically-adjusted price-earnings ratio is 26.2. That is high by historical

standards. But, of course, yields on bonds and cash are exceptionally low by

those same standard. So stocks look like the "least dirty shirt" on the washing

line.

Another factor may be that central banks are still pumping out liquidity; they

may not be buying equities directly but by forcing investors out of bonds, they

are boosting the stockmarket. Matt King of Citigroup notes a close correlation

between central bank asset purchases and the global equity market.

What will it take to drive the stockmarket down on a more sustained basis than

was seen in, say, February? It remains my view that this will not happen unless

there is a recession in America (or more generally in the developed world) or a

sharp rise in interest rates. The latter looks highly unlikely at the moment.

And while the world economy is hardly booming (see the latest numbers on

Chinese trade), it is still muddling along. None of this means the returns on

equities will be very high in a world of slow growth, of course, especially

given the starting valuations.