RSS feedsAt the start of this year it appeared that common sense had finally prevailed as equity prices tumbled to reflect the impact of the credit crisis. But over recent weeks, equity markets have once again rallied despite credit markets continuing to languish.
This decoupling of the two markets has made strategists scratch their heads. Are there very different factors affecting the equity market compared with the debt markets or are equity investors in a state of denial about the full ramifications of the credit crunch?
Ian Scott, global and European equity strategist at Lehman Brothers, thinks credit markets have been pushed below their fair value. “There are a number of technical factors that are pushing these markets below levels justified by the current credit conditions. Limited liquidity, reduced investor risk appetite and balance sheet constraints have resulted in an unnaturally subdued market,” he says.
Delving more deeply into the equity market, other factors emerge to support Scott’s analysis. “Since 9 January, the share prices of companies with lower credit ratings have risen by an average of 5%, while those with the best credit ratings have declined by 4%,” says Scott.
The recent rally of those stocks with lower credit ratings indicates that the equity market is no longer concerned that these stocks will be in danger of defaulting, even though spreads have continued to widen in the credit market. Scott says this is further evidence that credit markets are artificially depressed. “Not only have equity and credit asset classes decoupled, they have also done so at individual stock level,” says Scott.
Michael Dicks, head of research at Barclays Wealth, believes the financial markets’ tendency to over-exaggerate price movements is to blame. “If you look back at historic asset price booms and busts, a good rule of thumb is that the more unrealistic prices look during the boom, the greater the pain when the bubble bursts.” Before the credit crunch, spreads had become ludicrously narrow. Many, including the Bank of England, were concerned such narrow spreads indicated that the market had had temporarily forgotten about the risk of investing. It’s not surprising, then, that the revaluation overshot when the correction came, says Dicks.
Predictable fall
A fall in the equity markets was highly likely given the probability that the
credit crisis could hamper growth of the global economy. “It’s not surprising
that equity prices should fall, but they should not fall as far as the credit
markets because the bubble was in the debt, not equity markets,” says Dicks.
This helps to explain why equity markets have held up better than credit
markets. Mitchell Fraser-Jones, product director for UK equities at Invesco
Perpetual, thinks the decoupling reflects the different outlooks of the two
asset classes on the future economic growth.
“The performance of the equity market implies that it believes the current economic difficulties will be largely confined to 2008. Bond markets, in contrast, seem far more worried about prospects for inflation, and that we may be in for a more prolonged period of stagnating economic growth. Shorter-dated bond yields have fallen to reflect lower interest rates and concerns over the growth outlook where as the longer-dated instruments are still high indicating that there are concerns about rising inflation.”
A more positive outlook for the global economy is not unreasonable. Most are forecasting only a contraction in global economic growth, even though there is a strong probability of the US going into recession – if it hasn’t already.
There are real concerns that the US and UK economies have become unbalanced and over-reliant on their consumer and housing sectors. “A weaker dollar over the past three years has gone some way towards helping to redress this imbalance; US exports are now soaring and the current account deficit is shrinking. It’s likely that we will have to go through the same sort of correction in the UK,” says Fraser-Jones.
Scott thinks the correction in equity prices has gone too far. “Global equities are currently trading on their lowest multiples since consensus data was first available in the 1980s. Analysts may well have to cut their forecasts further, but the 25% reduction needed to return the multiple back to average levels implies a greater downgrade to earnings estimates than seen during the last two recessions,” he says.
Fraser-Jones agrees that some company valuations have become compelling, but that uncertainty about the level of risk means that investors are sitting on their hands. “We still have no clarity about how long the downturn will last. As soon as we see a bounce in economic activity, it’s likely that we will have a very strong rally in equity markets.”
The decoupling has led to a widening of the yield gap between the two asset classes. Equity earnings yields and bond yields decoupled at the start of the millennium, reflecting the long period of low inflation that has kept bond yields down. Equities saw valuations slump during the 2000-03 bear market and have not recovered to the levels seen before the market crash.
The gap has widened further in recent months, with equity yields pushing out to 9%-10%, reflecting the market’s concern that companies will not be able to sustain their recent profit margin improvements.
Attractive equity prices and the greater likelihood of the stock market recovering before the credit market means that decoupling looks set to stay.
