Wednesday 17 July 2019

Dan White: Shares rise, but with no visible support

The markets may look as if all is hunky-dory, but the emergency steps taken by the ECB tell a different story

Dan White

LAST week's decision by the ECB to cut official eurozone interest rates to a record low of just 0.25 per cent looks set to drive share prices even higher.

With interest rates having shrunk to minuscule levels, investors are piling into equities instead.

The news from the ECB sent the DAX index of German shares to a record high.

Meanwhile, the Dow also hit record territory this week. In Dublin, the ISEQ climbed to a post-crash high.

Social network Twitter took advantage of the euphoria to launch its IPO on the New York Stock Exchange. The shares, which were priced at $26 (€19.40), opened at $45 (€34.31), valuing the company at a hefty $27bn (€20.1bn).

That's a lot of tweeting.

Only London's FTSE index, which hit a five-month high in late October, failed to join in the party. It fell on news of the ECB's rate cut amidst fears that it would push sterling up against the euro and hurt Britain's nascent economic recovery.

So what is driving share prices? Traditional economic theory holds that share prices are a predictor of the future direction of the economy. A rising stock market indicates that economic growth lies ahead, while a fall in share prices is a warning that a downturn looms.

On the basis of the markets' behaviour, this week all is sweetness and light on the economic front. If only this were the case. In the same week as German shares were hitting an all-time high, the European Commission was cutting its forecast for 2014 eurozone growth from an already anaemic 1.2 per cent to just 1.1 per cent. That's not the sort of economic growth that could normally be relied upon to push share prices to record levels.

Indeed it was fears that the eurozone economy was about to slide into recession once again, with average inflation across the single currency area now down to just 0.7 per cent, that prompted the surprise interest rate cut by the ECB last Thursday.

Meanwhile, the emerging markets bubble has burst, with several former stars including Brazil, India and Turkey now looking very ropey. Even China, the one bright spot in the world economy since the 2008 crash, appears to be slowing. Double-digit growth is now a thing of the past, with the Chinese economy expected to grow by "only" 7.5 per cent this year.

Closer to home, the Irish economy is also likely to disappoint. The EU Commission has cut its forecasts for Irish GDP growth in 2013 from 1.1 per cent to a barely perceptible 0.3 per cent and its 2014 forecast from 2.2 per cent to 1.7 per cent.

Even the outlook for the United States, by far the best-performing of the developed economies, remains uncertain. While the latest figures from the Commerce Department show the US economy expanding by a higher-than-expected 2.8 per cent in the third quarter, the fact that congressional Republicans were prepared to even contemplate default during last month's budget showdown should be enough to give investors reason to pause.

The rise in share prices – as was often said in court of an indigent defendant in less politically correct times – would appear to have no visible means of support.

If it isn't the prospect of better economic times around the corner, just what is pushing share prices ever higher?

Ever since the 2008 financial crisis, all of the world's major central banks have been using a combination of ultra-low interest rates and easy money as they seek to prevent a nasty recession from morphing into a full-blown depression.

Last Thursday's move means that the ECB now joins the US Federal Reserve and the Bank of England in having cut its official interest rate to just 0.25 per cent. In addition to cutting interest rates to as close to zero as makes no difference, the major central banks have also flooded the markets with cheap money.

'Meanwhile, the emerging markets bubble has burst'

In the US, the Fed is buying $85bn (€63.4bn) of bonds every month, or over $1 trillion (€764bn) a year. On this side of the Atlantic, the Bank of England has bought £375bn (€450bn) of UK government bonds as part of its programme of quantitative easing. Even the ECB, in the teeth of fierce German opposition, has also committed itself to purchasing up to €524bn of Spanish, Italian, Portuguese and Irish government bonds.

However, in proportionate terms the daddy of them all has been the massive bond-buying programme unleashed by the Bank of Japan following prime minister Shinzo Abe's decisive election victory in December 2012. The Japanese bond buying programme is currently running at an annual rate of up to 70 trillion yen (€532bn).

While bond buying by central banks has undoubtedly helped stave off a 21st-century great depression, it has had some unintended consequences. With interest rates at close to zero and trillions of euro, dollars, pounds and yen looking for a home, investors have been piling into shares. It is the excess liquidity created by central bank bond buying rather than any improvement in the prospects for the global economy that is driving share prices.

This leaves equity markets very vulnerable to a change in central bank policy. To see what could happen one has only to cast one's mind back to last May when chairman Ben Bernanke announced that the Fed was considering "tapering", ie reducing, not scrapping, its bond-buying programme. Share prices fell sharply and bond yields jumped before Mr Bernanke was forced to row back.

With equity values at artificially high levels and most central banks looking for ways to at least scale back their bond purchases, investors should be afraid – very afraid.

Sunday Independent

Today's news headlines, directly to your inbox every morning.

Don't Miss