As I write, stock markets worldwide are heading back to their highs for the year after the "correction" of late February to early March. Indeed, global equity indices are hitting all-time highs. The US stock indices are still shy of that but continue to improve.
However, I remain cautious and doubt that the great bull run in equity prices that we have seen since March 2003 is going to continue for much longer. I believe that is primarily because the excessive credit that has built up in the world’s financial sectors, particularly in the US, is set to contract sharply as the global cost of capital rises.
At the short end of the interest rate curve, central banks throughout the world have been increasing rates. In the first quarter of this year, interest rate rises were imposed by the European Central Bank, the Bank of Japan, the Bank of England, the Reserve Bank of Australia, the Reserve Bank of New Zealand, the Reserve Bank of India and the South African Reserve Bank, to mention the main ones. Up to now, that has had little effect on the cost of capital for corporations and households.
That’s because their cost of borrowing depends on the yields of longer-maturity bonds. And here the huge expanding derivatives and debt markets have absorbed or delayed the impact of central bank interest-rate rises. Yields for two-year to five-year sovereign or corporate bonds have stayed static or even fallen.
My view is that this state of affairs cannot be maintained and that eventually the bubble will burst and liquidity will contract as quickly as it expanded, with highly negative results for the financial sector and financial assets.
And there is another factor that is increasing the risk of a bursting bubble: profits. There has been a profits bonanza in the US, Europe and Japan over the past five years. But that is now coming to an end, particularly in the US.
US S&P 500 earnings per share have been growing at a double-digit rate for more than three years. However, in the fourth quarter of 2006, earnings were up 12.5% year on year, a sharp slowing from 20% year-on-year growth in the previous quarter. And they could rise just 3% to 4% this year at best.
Indeed, according to my colleague, Daniel Casali, if it were not for the financial sector, US corporate earnings would barely be growing at all. A massive 77% of annual earnings growth in the fourth quarter of 2006 came from the financials. Apart from record M&A and IPO activity, this stellar performance was boosted by mortgage lending. However, the downturn in the US housing sector means that this will be difficult to sustain.
| How the numbers stack up |
| Contributions to annual US corporate profit growth |
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| Source: Datastream |
Another reason to expect a profits slowdown is lower oil prices. Falling oil prices have hit the oil majors hard, where earnings were down 8% year on year. This nipped 1.4 percentage points off overall US earnings growth in the fourth quarter of 2006, after contributing five percentage points to total earnings growth (a contribution of one-third) in the previous two years. What is happening among the top-listed corporations is being repeated for the US business sector as a whole. National accounts data show that energy stocks and financials accounted for a whopping 71% of annual corporate profit growth in the fourth quarter of 2006. Profits in the financial sector grew a record 60% year on year in the third quarter of 2006, slowing to 27% year on year in the fourth quarter of 2006.
Little further up side
Overall corporate profit growth is going to slow too. The non-financial corporate sector made a much bigger contribution to economy-wide profit growth than non-financials did for the S&P 500 universe. Indeed, the non-financial corporate profit margin has risen more than in any other business cycle since the 1950s. But this very strength suggests that there might be little further up side.
Rising labour costs are now being accompanied by falling corporate pricing power. The fourth quarter of 2006’s non-farm business sector’s implicit price deflator grew 1.9% year on year, nearly one percentage point slower than unit labour cost growth.
Indeed, US pre-tax profits in the fourth quarter of 2006 fell slightly for the first time for more than 18 months. And corporate profit margins stood still. Indeed, if the financial sector and profits from abroad are excluded, US corporations suffered a fall in profits.
I reckon that this marks the end of America’s recent profit expansion. And should profits disappoint just when positive sentiment in global equity markets seems to be evaporating, investors are likely to dump stocks. I’m staying very cautious amid the optimism.
David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com