This time IS different for equity markets

Observant investors over the last 30 years should be looking at the current markets and thinking that an opportunity to buy into equity markets may be at hand. Following some inflation fears in 2010 and 2011, inflation across the world has declined markedly in 2012 and looks set to decline further to levels below the targets that Central Banks have set. Further, economic growth is slowing markedly and has now become a greater economic and political risk than inflation. Policymakers’ focus has clearly shifted from concerns about inflation to concerns about growth. Historically this shift in focus (1982, 1988, 1992, 1998, 2002 and 2009 saw similar shifts) has been a clear BUY signal for equity markets – in today’s conditions this is further supported by very low valuations on equities.

In these previous cycles, the shift in policymaker focus led to substantial policy easing, principally via lower interest rates, which boosted consumer disposable income, boosted consumer confidence and encouraged demand for mortgages for house purchases.  This led consumer demand as a whole and thus an economic recovery. Equity markets rallied as they foresaw this pattern of events.

Sadly, however, this time is different. Policymakers certainly wish to boost demand by policy easing but the key differences this time around are (i) interest rates are essentially at zero and cannot be cut meaningfully, (ii) government deficit and debt levels have reached levels that terrify even the politicians and so fiscal policy has been neutered, (iii) the financial system is so badly damaged from its period of excess up until 2007 that it is no position to start lending again despite heavy political pressure, (iv) consumers now feel that in aggregate they allowed their debt levels to rise too sharply and wish to lower them and (v) consumer confidence in their economic future has been so badly damaged that many do not wish to borrow anyway.

The only policy stimulus open to governments and Central Banks is further Quantitative Easing (“QE”) or money printing. So far all the extra money that has been created has remained in the financial system and not found its way into the real economy – this is not to say that QE has been useless; it has not.  Indeed the financial system and the Western economies would be in a far worse state today if there had been no QE.  In addition, the long-running Euro saga has meant that the Eurozone has had to adopt very restrictive fiscal policies in an attempt for the weaker governments to maintain support from the markets and from the stronger Euro members, making the Eurozone economy much weaker than it needed to have been.

So this time, the usual cycle of policy easing leading to consumer recovery and thus economic recovery together with improving equity markets is unlikely to occur.  It is true that equity markets are cheap by historical comparison, and this should limit the downside potential for equity markets in the absence of a severe recession which would damage earnings. However, equities lack the usual reasons for investors to buy them, and so upside potential is also limited until some shock or crisis leads to a radically different policy approach.