Will China bring this market down?
Posted on September 25, 2007 by Richard Beddard
Filed Under Markets |
Though the the bail-out of Northern Rock and the fragility of banks in the face of a credit crunch seem serious, the stock market has actually risen since the news broke nearly two weeks ago. It’s an indication, perhaps, that things are not as bad as they seem, an observation borne out by credit spreads.
As a bull, when everything else appears to be falling apart, it’s reassuring to revise the arguments for a rising stock market and check whether your assumptions still hold true.
Regular readers of this blog will know that, on the advice of Ken Fisher, I adopted the spread between the earnings yield and the bond yield as the principle yardstick for the health of the market. It’s tricky to monitor as the ‘market’ we are talking about is the global market in company shares and its health is measured using the MSCI World earnings yield and Fisher Investment’s own World Treasury yield, information that is not generally available.
Fisher Investments tells me on 13 September the earnings yield was 7.3% and the bond yield was 4.1% putting the spread at “a hefty” 3.2%. That means world stock markets are still in an unprecedented ‘goldilocks’ phase where debt is cheaper than equity. Not only that, last time I checked, in June, the gap was 2%, so it has actually widened*1. That’s because share prices have fallen since then and long-term government bond prices have risen, making the earnings yield look even more attractive relative to the bond yield.
A spot of revision for you: when debt is cheaper than equity, companies use it to finance share buy-backs and takeovers. That pushes up share prices, as the supply of shares diminishes and demand for shares rise. It’s the mechanism that drove the stockmarket up from the lows of 2003, and the size of the gap indicates the market still has a long way to go. Once the debt markets free-up, the buying spree should accelerate again.
Ken says the ‘credit crunch’ simply isn’t big enough to get in the way of the bull market. Assuming that to be the case, I put to him a story that is potentially much bigger: China.
Alan Greenspan says China’s rapid conversion to capitalism, in particular its low cost exports, enabled Western economies to grow unencumbered by inflation. But that’s a one-off event, soon to end (pdf: interview with the Daily Telegraph). As tens millions of Chinese become consumers, demanding higher wages and paying higher prices, a return to inflation and/or high interest rates lies ahead, says the former chairman of the US Federal Reserve:
I think the real political problem is going to occur when the central banks will recognize the extraordinary benefits of low inflation on economic growth – and they have the capability of doing that but only at significantly higher real interest rates.
I think inflation is a more likely bull-market killer than the current credit crunch*2, especially if it’s on a Chinese scale. Quoting figures from the US Bureau of Labor Statistics, the Wall Street Journal Blog says prices of Chinese manufactured goods have risen for four consecutive months. Higher prices and interest rates could undermine corporate profits and reduce the earnings yield, while inflation pushes up bond yields, closing the gap between the cost of debt and returns from equity. There’d be a cruel symmetry if China were to take this bull market down, having played such an important part in pushing it up.
If inflation takes off, our bull market machine could go into reverse. The demand for shares falls because rising prices means companies aren’t so profitable, and the supply of equity increases as interest rates rise, debt-funded buy-backs dry up and companies fund investment by issuing new shares. It doesn’t necessarily mean a bear market, but in the absence of anything else driving the market up, it could.
Ken’s unimpressed by my burgeoning scare story. He’s sanguine about inflation, saying it’s a global phenomenon and one country’s inflation can be offset by another’s deflation. As for Alan Greenspan, he says:
He has simply become a grumpy old man. Mr. Greenspan was a great Fed head, but capital markets were never his bag.
Unfortunately I ‘aint no Alan Greenspan, so it’s a one sided debate at the moment. But it takes years for rising prices to work through the economy, so the inflation theory wouldn’t jeopardise Ken’s bullish forecasts for this year. It will be interesting to see what happens to the spread between the earnings yield and the bond yield after that.
Footnotes
- A sharp-eyed correspondent has already noted that 13 September was before the half-point reduction in the US Federal Funds Rate. I’m not sure how significant that is, as the bond yield used to calculate the spread is a global bond yield but Treasury yields rose slightly in the US after the interest rate decision, because of inflation fears.
- See this article in The Economist. It says bail-outs on both sides of the Atlantic show it’s politically unacceptable to prick a debt bubble by allowing debtors to default and savers to lose their savings. The alternative is inflation, which eases the burden of repayment.
Comments
6 Responses to “Will China bring this market down?”
Leave a Reply
Interesting post…
I think I read somewhere a month or two back that the Asian stock market is priced at around a P/E of 40-45. That is of course based on speculation that profits will continue their growth at the rate they have been growing.
I do not think that globals yields will necessarily push up or down the UK market, apart from the overall outlook ie if the world outlook is bad then that will effect the UK. The uk has its own problems to deal with namely the high levels of debt held by Uk citizens, which has been expanded by the massive inflation of house prices over the last 10 years. If this bubble bursts then we will see an immediate downturn in overall share prices in the UK.
Just something I would like you to clarify about the bond/equity yield gap, because I do not know much about this yardstick and am a bit confused. You are looking at the gap between equity yield (the return on equity) and bond yield (the effective yield paid to bond holders).
First what I do not understand is that bond are issued by governments and corporations to raise finance. Although this may mean companies (e.g. BT) have motivation to buy back shares because as you say debt is cheaper than equity, how does this relate to Joe public who cannot get this kind of cheap money.
I had always assumed that the equity/bond yield gap was used as a means of judging how investors felt about the market. e.g. if they are confident in shares then the bond yield would tend to go up and visa versa (current interest rates also need to be factored in in this context). In that case could not the low bond yields be telling you that the market is over valued?
The other thing is you say that relatively low bond yields means equity is cheaper than dept, but how does this extend to the average investor, who has to borrow money at a much higher interest than bond yields?
Good stuff Beddard - san ..
BUT there must be a day of reckoning , n’est pas ..
Kazumi ..
Another grumpy outpouring about China I am just glad I did not sell out of my modest China Red Chips earlier this year when my Grumpy Old Men friends in the City were preaching nothing short of meltdown. For a variety of reasons a lot of people love knocking China often based on a quick visit to the Forbidden City! Very dangerous to apply Western Values to what is still a Command Economy with very high growth rates!
Hi folks, thanks for your comments.
Deborah, I agree PE’s like that are scary and sound unsustainable, so something else to ponder
Paul, maybe - maybe not. The FTSE is increasingly global and the question is whether a local shock would be big enough to undermine it enough to turn the bull market into a bear market. We’ve seen a lot of scares so far that haven’t been, and I suppose the point of clinging on to the coattails of the earnings yield/bond yield spread is that until the market’s overvalued and there’s a degree of hype in the price it’s likely to go on rising, albeit suffer the occasional set back. That’s the argument, anyway.
John, I think this market isn’t being driven so much by private investors as private equity, takeovers and share buy-backs within companies. Ken Fisher would say this isn’t a bubble, it’s a perfectly rational reaction to the spread between earnings yields and bond yields. Perhaps when private investors do get involved in the way they did in 1999/2000 - that will be a time to worry.
It’s an interesting point you make about bond yields being low because investors are wary of the stockmarket (by implication they prefer to put their money in bonds). But doesn’t it just confirm that share prices are low? Unjustifiably so while the earnings yield is, relatively speaking, so high?
Kazumi, There must indeed. I’ve cheekily intimated it might be in 2009, but really I just don’t think it’s imminent.