Saturday 20 July 2019

Market ups and downs will keep life interesting

SUPER MARIO: Equity and bond prices have risen, thanks to President of the European Central Bank Mario Draghi. Photo: Reuters
SUPER MARIO: Equity and bond prices have risen, thanks to President of the European Central Bank Mario Draghi. Photo: Reuters
Ronan Reid

Ronan Reid

I WAS going to write this column in defence of stockbrokers after Shane Ross's column last week but I am only a stand-in, which would leave Mr Ross with an unchecked right of retort, a dangerous situation for a Dublin stockbroker.

Instead, sitting at my desk, looking at a photograph of my 18-year-old son when he was aged three, I am reminded of the speedy passage of time; his desire to progress and grow and my preference for life to stand still. This is a world of dichotomies.

Markets have dichotomies too. The US is growing steadily but European economies are spluttering like that lawnmower in spring: rattling, noisy and moving slowly.

Divergences have appeared on the economic and the policy front. The ECB is getting ready to pump out more money. The Fed decided to taper off – to reduce – the flow of cheap money, because it was no longer needed, and to curtail asset inflation. Global investors are generally free to buy all equities and bonds, so their prices have risen, courtesy of ECB president Mario Draghi and former Fed chairman Ben Bernanke.

The US supply of free money will now slow and China has announced that it has no need to continue building foreign exchange reserves – both steps which reduce the supply of money to the capital markets of the world. So the risk-free rate of return will rise over the next few years.

The world rally in bond prices seems to be close to an end, and equity price appreciation has exceeded profit growth and property price moves have exceeded rental growth, so what assets will suffer most?

Over here, bank share prices rallied but as the first entrants exited, in this case BoI investors, prices spluttered a little as it dawned on investors that the path to profitability is quite different in each of the banks.

Bank of Ireland should have returned in the current first half of this year, with AIB to follow by year-end, but PTSB will continue to use capital until 2017. Moodys remained negative on bank debt but upgraded our national debt. Strange, as one is linked to the other, and they failed to appreciate the likely improvement in the credit quality of the banks' mortgage books as unemployment, or fragile employment – a primary determinant of mortgage arrears formation – improved.

Mortgage arrears, although elevated, have already started to trend lower. Banks seem to be making real efforts to clean up their loan books. Demand for bank bonds has been strong, with BoI and AIB regularly issuing to a growing overseas audience.

Cheap money also brought global investors to Ireland and commercial property prices have increased as large commercial deals allow large deployments of capital. But be clear: these have been bought in the expectation of three-to-five-year returns and will need a functioning banking system to be sold on.

Irish house prices have risen by less. This is because money is not as free – it reflects a net interest margin banks need to regain profitability, and there is an absence of real new lending, the supply or demand for credit. Cash buyers have pushed house prices up off the bottom but the supply of houses will also increase over time as banks work out loan books. Properties that require less borrowing, such as smaller townhouses, have risen, particularly in locations where supply has been limited.

Asset prices are recovering but retailers and other real-economy businesses still struggle. Is it Irish GDP inclusive of multinationals that is important or GNP because it now looks better as the economy slowly recovers? Neither – we need consumer sentiment to improve. Better housing prices and an end to austerity should continue to improve consumer sentiment.

All better? It doesn't quite feel like it.

We all still work harder but the future is a little more certain and we are still clearing up the mess of the last few years. It will continue to get better; banks will reduce loan books and grow deposits and then will want and need to lend again. Credit feeds an economy. So let's bang the desk, but what then? Remember the laws of physics: to every action there is an equal and opposite reaction. If credit in Europe remains slow and more and more monies are ploughed into economies to force a recovery, then over a longer period rates will have to rise further as inflation threatens, but this will be a number of years out. Asset inflation widens the rich/poor divide so if employment does not rise, further direct incentives and government employment will be required. This will need to be funded and more bearish bond markets will be less tolerant of increased deficits, so taxation will need to increase.

Political moves to left of centre may result in an increase in the upper bands of taxation in a move to comfort those caught in a wider tax net.

Will inflation, as measured by economists, be a problem? I don't believe it will, but my buying power in core areas of my children's education, my own healthcare, and my own legal, insurance and investment needs will fall, due to cost and regulatory inflation, and my tax burden is unlikely to fall aggressively. Fortunately, the cost of my Leeds United season ticket won't rise too much, nor will the cost of travel and the day-to-day cost of living, outside of fuel. Dichotomies remain but they make life interesting and, of course, unpredictable.

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