In the modern era strong equity market performance in January is not, as used to be believed in days gone by, a reliable forerunner of a good year ahead for the stock market, which is a pity as 2013 has certainly got off to a roaring start, with both the S&P 500 and the world index up by 5.0%, and the main Japanese indices up by nearly twice that amount. After its lacklustre performance in 2012 the UK equity market produced an impressive 6.4% and China, a dark horse favourite for top performing stock market, a tad more. However, as this useful corrective note from Soc Gen’s top-rated resident quant Andrew Lapthorne makes clear, there are some curious features of the markets’ generally impressive performance that give cause to doubt quite how enduring this rally will in practice prove to be.
Firstly debt issuance by companies is riding high and a large chunk of this debt is being used to buy back shares. This creates a virtuous circle, where increasing debt issuance supports share prices, pushing down implied leverage and volatility at the same time, which in turn supports ever cheaper credit for the corporate. So, once again, with one of the key marginal buyers of equities the corporate, using capital raised in the debt market means that, as ever, the fate of the corporate bond and equity market are intertwined and as such last week’s weakness in the high yield bond market is worth keeping tabs on.
Another curiosity is sector performance. Basic Materials – the most cyclical of cyclical sectors struggled in January whilst defensives such as Health Care, Pharmaceuticals, Food Producers and Beverages all outperformed. It would appear that whilst investors were becoming more bullish about equities, they appear less enthusiastic on the prospects for the economic cycle. And we can understand why. For although the majority of US companies have (as is typical) beaten lowered expectations, 2013 forecasts continue to be reined in. The ratio of upgrades to total estimate changes continues to decline in most regions and remain at levels consistent with declining profits and a consequence of all these downgrades 120bps has been cut from 2013 global growth expectations in the space of just one month. In Europe ex UK the 13% growth forecast pencilled in at the beginning of the year has dropped to 10% and in the US expectations have gone from 9.7% to 8.4%. It would appear rising equity prices are disguising a multitude of sins.
No doubt we will find out soon enough if these concerns are justified. The trend of companies borrowing cheaply and then buying back their own shares has certainly been a striking feature of the US market for some time now; indeed, as Andrew Smithers has pointed out, corporates have been the only significant net buyers of equities in the last couple of years. That could change if investors have finally decided to move more of their money out of government bonds (where yields are negative in real terms across the front half of the curve) and towards equities. January fund flows suggest a hint of just such a trend, with US equity fund flows marginally ahead of bond funds for the first time since a brief flurry of optimism broke out in early 2011.
As economic growth and the stock market have a tenuous relationship at best, given that the latter discounts the future, not the present, the news that the US economy recorded no growth in the last quarter of 2012 need not mean that a serious fall in the stock market is coming. As we are clearly now overdue a correction, given how strong momentum has been in recent weeks, a period of relative short term market weakness is inevitable without it having to imply any change in fundamentals. However what is critical for the market this year is whether earnings can in practice over the course of the year beat the trajectory that the rising stock market is now implying. With profit margins still close to all-time highs, and inflated by the unusually low cost of debt and low tax charges, all one can say is that strong earnings growth, it it materialises ahead of current market expectations, will be a pleasant (and very welcome) surprise. I am certainly not counting on it.
Meanwhile the fall in yields on corporate bonds and high yield debt is becoming a real cause for concern. As the Soc Gen team pointed out at their recent annual conference, it is not a surprise that companies should be using the availability of cheap debt to help them buy back their own shares. The mystery is more why investors are so willing to lend them the money at what are historically such cheap rates. The search for yield at any price, although the direct and deliberate consequence of central bank policy, is taking us away from one danger (deflation) but towards another (a new and different kind of credit bubble). Even those of us who have put their faith in equities as the medium term asset class of choice are not foolish enough to expect a smooth upward ride.
Jonathan Davis 