On Thursday morning, I started making a list of all the things
that might upset the markets in 2011.
By 10.30am, it numbered 11 – and I hadn’t even got to the possibility of western governments hitting a funding crisis or to the odds of a new oil price shock.
My list started with the strong chance that China might land with a bit of a bump: it needs to take policy action to deal with inflation, and policy action all too often ends in tears. Then it moved through the troubles in Europe (will Greece leave? Will Germany leave? Will everyone leave?) and on to austerity and food-price-driven inflation sparking unrest across the globe.
Next came the collapse of our coalition government – something that, in the UK at least, would be bad news for deficit reduction and so bad news for both interest rates and growth.
Then there is war. Think Korea. Or Iran. Or Pakistan.
And then there are house prices. For the moment, they are being held up nicely in the UK by what Peter Warburton of Halkin Services calls the “extreme disincentive for vendors to sell other than when compelled to.” As the sum they can get for their most precious asset falls, they withdraw and the market tightens, keeping things sort of stable in nominal terms at least. But vendors won’t have this choice forever – the three Ds (death, divorce and debt) won’t allow them it.
Worse risks remain in the US property market. Graham Turner of GFC Economics sees another lurch down in prices in America as the biggest risk of 2011.
There has been a nasty rise in the “foreclosure inventory” (the number of borrowers being foreclosed) and a tumble in the number of houses being bought now that the US has stopped offering tax credits to homebuyers. Without more government support, there is every chance the prices will fall further leading to more defaults, something that would, in turn “push bank share prices down sharply.” The credit crisis of 2007/8, says Turner, “is not over”.
Depressing stuff isn’t it? I tried to cheer my day up with a new list, one of things that might keep the equity markets moving this year.
This was harder – partly because, now that recovery has been underway for 18 months or so, the capacity for positive surprise is rather less than it was. But also because – no matter how you cut it– global equity markets aren’t cheap.
As Société Générale’s Albert Edwards points out, on a cyclically adjusted price/earnings (CAPE) ratio, the US market remains seriously overvalued. So, unless this time really is different (and I’d bet a good deal that it is not), we can expect to revert to mean at some point.
Let’s not forget, as Edwards puts it, that while the history of the last 130 years or so has been both remarkable and appalling – “the deaths of empires, the birth of nations, periods of deregulation, periods of re-regulation, World Wars, revolutions, plagues and huge technological and medical advances – “none of these events mattered from the perspective of value”. The long run average CAPE remained much the same.
Given all this, you will be surprised to hear that I am not entering 2011 in a particularly bearish mood. Instead, I’m still pretty happy holding developed world equities.
I’m not worried about valuation in the short term. The CAPE is – so far – just about the only really reliable long-term indicator of stock market returns we have. But it is rarely much use to anyone in the shorter term. So, while we need to watch it, we don’t need to panic every time it flashes at us.
But my real reasons for staying in the market are twofold: quantitative easing (QE) is still with us, providing a nice liquidity cushion for all asset classes, and inflation – while rising – is at just the right level. It is high enough to badger people out of cash: 3-4 per cent is too much to lose in real terms every year and the pitifully low rates of interest on deposit accounts, along with the pitifully low yields available on government bonds, just can’t compensate investors in the same way solid dividends can.
Given this, Tim Price of PFP Wealth Management claims that “the outlook for high-quality equities” in 2011 is as good as he can ever remember.
All this might change of course: inflation is only good for equity markets as long as it isn’t high enough to be frightening. When it starts to move too fast, bond markets take fright, yields move up and equities tend to wilt.
This may well happen at some point in 2011.
I saw Adam Fergusson, author of 2010’s wild card bestseller, When Money Dies: The Nightmare of the Weimar Collapse, over Christmas and asked him if, given QE2, he would be surprised to see double digit inflation in the west in the next few years.
“Not remotely,” he said.
The fact that Fergusson’s book has been selling like hotcakes tells you he isn’t the only one who thinks this. But it hasn’t happened yet. And that makes staying invested a perfectly reasonable strategy for now.
Merryn Somerset Webb is editor-in-chief of Money Week and previously worked as a stockbroker. The views expressed