Central Banks Drive the Stock Market Boom

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Spring has sprung with a vengeance for stock market investors. In recent days we have seen the Dow Jones industrial average close above 15,000 for the first time, Germany’s Dax hit record levels and the MSCI world equity index reaching its highest level since before the worst of the global financial crisis in 2008.

Even the FTSE 100 has been joining the party, trading comfortably above 6,500 and within sight, though not for the first time, of its all-time high of 6,930, reached as long ago as December 1999.

What lies behind this outbreak of stock market optimism and is it a harbinger of better economic news to come, or just a flash in the pan? Are markets, as some suggest, divorced from economic reality? A strong German stock market is, on the face of it, hard to square with an ongoing eurozone crisis and a European Commission forecast of continuing recession this year.

Stock market strength coincides with some evidence that, partly as a result of the eurozone’s woes, world growth is slowing. The April J.P.Morgan/Markit global purchasing managers’ index (PMI) dropped from 53 to 51.9 in April, signalling that while upturn was continuing, it was at its slowest rate sionce October last year.

Some economic news, it should be said, is consistent with market optimism. Investors were cheered by the 165,000 April rise in America’s non-farm payroll employment and a drop in the unemployment rate to 7.5%. Strong March German industrial production and manufacturing orders encouraged the view that its economy is riding out the eurozone recession.

Though the FTSE 100 is more usually moved by global developments, Britain’s economic data has improved. The 0.3% rise in first quarter gross domestic product was followed by stronger purchasing managers’ surveys for April and the announcement of a 1.1% bounce in manufacturing output in March.

The better news, together with the National Institute of Economic and Social Research’s estimate that GDP grew by 0.8% in the three months to April (helped by the recovery from a very weak January), has taken the sting out of the International Monetary Fund’s current visit to Britain.

Even Christine Lagarde, the IMF’s managing director and George Osborne ally, warned last month that Britain’s growth numbers were not good. They are still not great but they are looking better.

Ian Harwood, economist with Redburn Partners, says there is nothing in the global PMI to suggest that growth in the world economy is seriously faltering, and he sees some evidence that the upturn in global trade – which had stalled – is gaining momentum again.

But the stock market rally is not, to repeat, mainly a reflection of better economic news, though that does not make it irrelevant to the economy.
Equity markets are reflecting the fact that risks appear to have diminished.

Though the eurozone is still in trouble, the fear of imminent collapse has abated. Banks are not out of the woods but are inching towards something that resembles normality. Investors have moved from “risk-off” towards “risk-on” behaviour.

Stock markets are also benefiting, however, from what looks like a win-win situation, for the moment at least. Share prices gain when economic news is good, because that means companies should do better. But they can also gain when the news is not so good, because that increases the likelihood central banks will engage in further asset purchases – quantitative easing – thus boosting markets via that route.

Johannes Jooste of Merrill Lynch Wealth Management notes that even when economic data has disappointed, as some recent numbers from America and China have, “continued easy monetary policy supported global equity markets”.

The Bank of England’s monetary policy committee stayed its hand on Thursday but other central banks are engaging in plenty of unconventional activity in the form of asset purchases, including America’s Federal Reserve, $85bn (£55bn) a month, and the Bank of Japan with a monthly $79bn (£51bn).

The European Central Bank, which cut interest rates earlier this month, is contemplating purchases of asset-backed securities made up of loans to small firms. The Bank, with Mark Carney set to arrive within weeks, may not have done yet. This month has seen a slew of interest rate cuts, from central banks in India, Poland, Denmark, Korea, Vietnam and Australia, amongst others.

Central banks will see the rise of stock markets as a good thing. It is one way their policy gets transmitted to real economic activity. Booming markets boost wealth, increase business confidence and make it easier for firms – larger ones at least – to finance expansion.

Rising equity prices do not always signal there are better times on the way (or, for that matter, worse times when they are falling) but they are better than the alternative. In Japan, the rising Nikkei, up more than 60% since August last year, is regarded as a sign that the Abenomics of prime minister Shinzo Abe is working.

But you can have too much of a good thing. When does the rise in stock markets, given that much of it is driven by the actions of central banks, become dangerous? When does it become a bubble whose bursting would be very damaging?

The risks are there, and they are present in the fact that markets have moved well ahead of real economic activity. Markets that are mainly driven by monetary policy are, by their nature, unsustainable.

Any sign central banks were ready to start tightening policy, by raising rates or selling back some of the assets they have purchased, would send markets diving.

That may not be entirely logical: central banks would only start tightening if they believed the economy was well through the worst, but markets are not always logical. The danger is that central banks get trapped by the markets into keeping their foot on the monetary accelerator too long.

This piece is cross-posted from David Smith’s Economics UK with permission.