Investor/An Insider's Guide to the Market: September is proving to be an excellent month for equity markets, thus soothing the somewhat frayed nerves of equity investors after a decidedly edgy summer.
Over the past four to five weeks, most equity indices have risen by between 3 per cent and 6 per cent, with the ISEQ Overall Index performing at the top of this range.
It is difficult to find any single catalyst for this improvement in share prices. Positive developments include the retreat in the oil price from close to $50 per barrel back into the low $40s. A shift in expectations regarding interest rates has also helped sentiment in equity markets as a somewhat slower pace of US economic growth has prompted forecasters to predict interest rates will continue to rise at a snail's pace.
A curious feature of recent trends in financial markets is that bond prices have been rising in tandem with equity prices. Rising bond prices (and lower bond yields) usually signal that inflation is subdued and sometimes may signal that economic growth is also subdued.
The accompanying table shows that government bond yields have been declining slowly but steadily since the end of June. For example, the Irish 10-year bond yielded 4.24 per cent at end-June but currently yields 3.92 per cent.
Ireland is, of course, part of the euro zone and the decline reflects the falls in euro yields across the region. Over this period, the ECB has kept short-term interest rates at 2 per cent, although it has signalled that it would start raising rates if higher oil prices were to feed through into higher consumer prices.
In contrast, both the US Federal Reserve and the Bank of England have begun the process of raising short-term interest rates, albeit in modest, quarter-point moves.
In the context of rising short-term interest rates, the fact that bond yields in the US and UK have also declined in recent months is particularly significant.
In the US, 10-year yields have fallen from 4.6 per cent at the end of June to the current level of 4.1 per cent, a fall of 50 basis points.
The explanation is clearly bound up with an unexpected slowdown in the pace of US economic growth over the summer months.
Alan Greenspan refers to this as a "soft patch" in the economy and the Fed has consistently argued that as such, it will eventually prove to be transitory.
If the Fed's analysis proves to be correct, then US bond yields should go higher when faster growth resumes. The fact that they have fallen suggests bond investors are taking the view that this "soft patch" in the economy may last for longer than expected.
In the UK, the much smaller decline in 10-year yields from 5.09 per cent at the end of July to the current 4.92 per cent may not seem significant at first sight. However, this has occurred after a series of five quarter-point hikes in interest rates from the Bank of England to bring official sterling rates to 4.75 per cent.
Most commentators expect rates to rise further, which could leave 10-year bond yields at current levels below short-term interest rates.
This recent pattern of movements in short-term interest rates, long-term government bond yields and equity-market indices does not fit in neatly with economic theory.
Rising short-term interest rates indicate that the monetary authorities believe economic growth will be strong enough to push economies towards full capacity over a one-to-two-year timeframe. Stronger equity markets indicate that equity investors are buying into the strong growth scenario.
If this is the correct interpretation of prospective trends, bond yields should be rising and not falling. Therefore, this summer decline in yields is beginning to reopen the debate about whether deflationary forces are still at work in the global economy. Excess supply of goods from Asia combined with a collapse in consumer demand in America are the two factors that could cause the world economy to slip into a period of very low growth and declining prices.
In this scenario, the rising oil price acts to exert a further deflationary shock to an already weakening environment.
If the deflationary analysis of global economic developments is correct, then bond yields would fall much further and could ultimately reach extremely low levels. The experience of Japan in the 1990s provides a salutary lesson in this regard.
Central banks would be forced to reverse the current tightening bias of monetary policy and would have to reduce interest rates sharply. Of course, the problem they would face is that interest rates are already at very low levels, thus limiting the ability of such a policy to stimulate economic activity. In this environment, share prices would almost certainly enter a new bear market.
Investor takes the view that although the deflationary threat is real, the chances of it actually occurring are extremely low. Even if the current soft patch in the US economy proves to be prolonged, it will probably be met with a pause in the Fed's policy of raising interest rates.
While demand may not be very strong in many of the world's major economies, there is very little evidence that it is about to weaken sharply. On balance, global economic growth should continue to be reasonable over the next one to two years and therefore equity markets should deliver solid returns.
Therefore, the recent decline in long-term bond yields is likely to be reversed at the first sign of faster economic growth and equity indices should then be able to build on the recent gains.
