As widely anticipated, the start of the Iraq war proved a catalyst for equity markets to rally, al...
As widely anticipated, the start of the Iraq war proved a catalyst for equity markets to rally, albeit starting from a depressed level ' at the low point the FTSE All-Share Index offered a dividend yield in excess of the 10 year gilt yield. A rally of sorts has been justified because some of the worst fears in terms of the duration of the war and damage to the oil fields have not materialised.
Encouragingly, while the rally was initially led by financials, it has broadened out to other sectors. An optimist would argue that further recovery is achievable as the effect of aggressive reflationary policies start to kick in. The end of the war could also trigger a rebound in confidence that would help boost corporate investment. This positive scenario would be helped considerably if the oil price continues to fall back, thereby easing pressure on costs.
While confidence may improve and the oil price is more likely to trend towards $20 than rise back to $30, we are more bearish that structural issues will not readily be resolved by lower interest rates and tax cuts. Excess capacity and high corporate indebtedness built up in the 1990s will remain an impediment to stronger economic growth and will keep profits under pressure, delaying a recovery in capital expenditure as companies continue to rebuild balance sheets.
Additionally, the consumer has been the main driver of growth in the US and UK in recent years. Although consumer spending may not collapse, the boost from the housing market via mortgage equity withdrawal has probably peaked given the levels of personal debt and signs of slowing house price inflation, so spending should begin to soften. In the absence of a sustained pick up in corporate investment, this would result in continued subdued economic growth. There is, however, downside risk if unemployment picks up more markedly.
This debate will not be resolved quickly because it is difficult to distinguish by how much poor economic data is due to Iraq-related uncertainty and the pre war oil price spike and how much by underlying weakness. Similarly, a degree of corporate spending recovery is possible, but this could be short lived and much of it inventory rebuilding rather than new investment.
The Fed and the Bank of England regard the risk to economic growth as bigger than the risk of inflation and are prepared to loosen monetary policy further. Europe, however, seems more reluctant to act in this way but may be forced to cut rates more aggressively should the euro keep appreciating. If the hoped for pick-up in corporate investment does not materialise and unemployment keeps rising, the expectation is that the Fed will pursue more unconventional policies to reflate the economy such as buying government bonds.
Short term, these actions may be seen as a further positive for bond markets. However, if successful this could mark the end of the bull market in bonds with yields rising as inflationary expectations increase. In the meantime, expanding budget deficits in the US and UK will have to be financed by an increased supply of debt which should put pressure on yields and threaten the safe haven status of government bonds.
End of war will help confidence.
Weaker oil price boosts activity.
Fiscal and monetary policies supportive.
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