This time, it really is going to be different
A year ago the world was heading for another crisis. Now markets are booming. Jeremy Warner looks for answers.
'Why did nobody see it coming?", the Queen asked four years ago on a visit to the London School of Economics - a brilliantly faux naive question that cruelly exposed the failings of modern economics. Well, here's another in a similar vein she might like to ask when she next returns to matters financial. "How come the sharemarket is going up, when the economy keeps tanking?"
The textbook answer to this question is that share prices don't reflect the world as it is, but as investors expect it to be a year or two from now. Markets are forward-looking indicators, not backward ones.
There is also a large element of relief in the continuing rally. A year ago, the world economy seemed to be falling apart. Political deadlock threatened budgetary mayhem in the US, the euro appeared to be at death's door, and China looked destined for a hard landing.
None of these things happened. It was a narrow miss, but thanks largely to the actions of central bankers, the anticipated meteorite strike passed us by. Financially, at least, the world today is a less worrying place than it was.
Yet none of this fully explains the strength of the rebound, with the Dow back at a record high, London's FTSE100 not far off it, and markets elsewhere soaring. Can it be that the sunlit pastures are at last in view?
It would certainly be nice to think so after five years of blood, sweat and tears, and I don't doubt that sentiment is a lot more positive than it was. Unfortunately, it's failing to filter through to the corporate world, where cash accumulation, not business expansion, continues to be the name of the game, at least as far as stagnant advanced economies are concerned.
It's a different story in fast-growing emerging markets. To the extent that Western companies are investing beyond the bare minimum to keep things ticking over, this is where their money is heading.
In any case, chief executives are not yet expecting the strong cyclical upturn which markets seem to be pointing to. If companies themselves don't think highly enough of our economic prospects to start investing, how come investors do? There are two interrelated explanations.
One concerns a major curiosity of the present downturn. To many, this has looked like a full-blown depression. Britain has actually had a deeper and longer contraction than that of the 1930s. But it's not felt that way to companies, outside the banking sector at least. After a brief, post-Lehman dip, largely caused by collapsing financial sector returns, corporate profits have soared.
Earnings are at record levels, and corporate balance sheets have never been stronger. Corporate insolvency, especially of the big, household name variety, is comparatively rare, making this a very unusual downturn by past standards. Normally, during a prolonged credit squeeze, companies go out of business in their thousands. But it's not happened this time on anywhere near the scale you'd expect for such a prolonged economic malaise.
Why? One reason is zero interest rates, allowing companies which, in a conventional recession, would have gone bust, to stay in business. At the same time, banks have been bailed out, so that bad debts have in effect been nationalised. Taxpayers rather than investors are being made to pay the price for past excesses. The insolvency problem has been transferred from the private to the public sector.
In this sense, action by policymakers has ensured that this time really is different. It's labour rather than capital which has been most damaged by the downturn. In sending share prices to record highs, investors are only just beginning to catch up with this reality.
The other related explanation is central bank money printing. This may or may not have prevented a much deeper economic collapse, but it has certainly put a rocket under asset prices. In Britain alone, the Bank of England has pumped £375 billion ($549 billion) of quantitative easing into the system. If it is right that the government is about to rewrite the Bank of England's remit so as to favour pursuit of growth over low inflation, we can expect plenty more where that came from.
Both the US Federal Reserve and the European Central Bank have been doing much the same, albeit via the banking system in the case of the ECB. Joining the party is the Bank of Japan, which promises to print yen without limit until finally it has succeeded in getting some inflation back into the economy.
All this new money has to go somewhere, and since it is not obviously doing much for the real economy, equities are increasingly the home of choice. As long as the central banks keep printing, equities will keep rising. Thus do central banks answer each bubble by blowing up another.
Actually, I wouldn't say that equities are yet a bubble. Valuations would need to move quite a bit higher for this to be the case. For the moment, they are still reasonably well supported by the surge in profits. But as with much else in this downturn, we don't yet know for sure what's really going on.
Is the upswing in sharemarkets a sign of a wider return in confidence that will eventually find expression in the real economy, or is it a largely artificial phenomenon that will last only as long as the QE? If this rally is to be sustained, then eventually the real economy is going to have to catch up with the sharemarket, but such are the distortions of central bank money printing that it could be some time before the sharemarket is made to catch up with a stubbornly resistant real economy.
In a lecture this week, Sushil Wadhwani, a former member of the British Monetary Policy Committee, observed it used to be thought that higher inflation was quite bad for equities, yet in a zero interest rate world, Mr Wadhwani said, "it would be reasonable to expect a positive association". Many companies have been able to push up prices even as wages and employment stagnate. Prices have proved "stickier" than wages. As we have seen, corporate margins have expanded accordingly.
Equities can thereby be seen as a relatively good hedge against central banks hell-bent on maintaining nominal GDP growth through elevated inflation. It is not until you get to levels of inflation significantly above 5 per cent that it becomes significantly earnings destructive.
Nonetheless, the logic of the argument carries an obvious warning. Eventually it becomes socially and politically unacceptable for companies to keep expanding their profits at the expense of labour.