AGAINST a background of a return to strong growth accompanied by a very solid fourth-quarter corporate earnings season in America and with early European corporate profit reports reflecting positive trends, it seems strange that global equity markets should choose this moment to go into reverse.
The explanation for this perverse behaviour is simple. Rather than simply enjoying the sharp reversal in fortunes that has characterised the previous nine months, investors are now being forced to look forwards to the second half of 2010 and beyond. Many increasingly fear that they may have confused volatility (as economies and markets have snapped-back from overly depressed levels) with sustainable momentum.
These nagging doubts spring from the undeniable fact that in the developed world the consumer is in no position to drive growth forward. Unemployment levels are set to rise further, tax rises look inevitable and the financial system undergoing running-repairs has neither the appetite or the ability to revive their animal spirits. Until this last situation is corrected – which takes time - we are unusually reliant upon our governments and demand derived from overseas developing economies to underwrite growth.
This being the case, there is understandably heightened sensitivity to signs that authorities in the developed world are now beginning the process of withdrawing extraordinary support measures, whilst at the same time the key growth engine in developing markets (China) is moving to moderate its own stimulus. The “icing on the cake” for those of a cautious disposition is the sight of the EuroZone dealing with the stresses of applying a single currency regime to many different economies. For equity investors who are relieved to have regained much lost ground, the logic for taking some chips off the table becomes clear.
However, there are strong reasons for believing that this correction will not turn into a rout. The most important of these is the health of the non-financial corporate sector, where profit margins are close to the levels achieved at their peak in 2008. With balance sheets also in a healthy state, companies are well placed to withstand unexpected adverse developments and the likelihood is that, absent external shocks, more favourable employment and investment trends will soon become evident. In addition, government support remains strong.
Whilst some stimulus measures are set to be withdrawn, these are only the extraordinary “printing press” measures (known in the UK press as “QE”) adopted to counteract a dysfunctional credit market. Conventional monetary policy remains very stimulative, which manifests itself in the unappetisingly low interest rates available to depositors at their high-street banks.
The positive side of this is that many of these funds are hunting for higher returns and are prepared to accept modestly higher risk to achieve them. Hence creditworthy borrowers in the corporate sector are finding it easy to access funds in the corporate bond markets.
In short, the machine of capitalism may be running at a reduced rate of revolutions, but it is once again creating wealth, not destroying it. With this perspective, the issues in the EuroZone debt markets do highlight one important point, which is that the principle “risks” to an ultimately benign outcome are now political, not systematic.