The FTSE 100 could reach 10,000 over the next five years as the final liquidity-driven phase of the ...
The FTSE 100 could reach 10,000 over the next five years as the final liquidity-driven phase of the equity bull market runs its course, according to Michael Hughes, head of Baring Asset Management's UK investment management team.
Hughes said this final bull market phase, which began in 1999, is characterised by the emergence of money flows as the dominant force affecting markets.
He has also identified three previous stages that date back to 1981, when he believes the bull market really began. Stage I saw inflation lowered, stage II saw the equity risk premium lowering as corporate restructuring began to prevail and stage III saw a reduction in the cost of capital.
Hughes commented: "The fourth stage in the bull run we have called the liquidity stage. There are multiple sources of new liquidity which makes this stage difficult to measure. Banks, having reported record profits, are eager to lend.
"Since many companies are being paid to take risk and because the cost of capital is below the expected return by a wide margin, the demand for credit can be expected to rise.
"The arrival of stakeholder pensions promises to establish the next big retail savings product, boosting retail flows into equity markets. The appetite for risk is increasing again.
"Large investment banks and hedge funds that had been caught out by the Russian default and Asian financial crises ran for cover during 1998. The rebuilding of their profits and confidence during 1999 has encouraged them to increase their risk positions.
"Perhaps the biggest boost to liquidity, however, will come from the change in monetary policy. This is a global phenomenon and not just one for the UK. Inflation targets have been substituted for money supply control. Interest rates are being set by deference to an inflation target.
"The problem arises if inflation is being held down by a series of powerful factors. Competition from internet providers and new companies, together with a strong currency, can keep inflation under control and therefore restrict the degree of any rise in short-term interest rates.
"Unless the Monetary Policy Committee takes account of rises in other asset prices such as shares, houses and land, the likelihood is that interest rates will be held below their equilibrium rate, therefore credit demands will be stimulated. Even if this is not the case, the increase in the supply of finance could prove to be more powerful than increases in the price of credit."
The resulting sense of an 'economic boom' will fuel equity prices and talk of a golden economy will spread, according to Hughes.
"If tax changes are introduced to further encourage entrepreneurial activity then the sense of a new era of economic prosperity will develop. In this era lie the seeds of the next bear market, but not just as yet.
"While the fourth phase of the market may be the most speculative, fuelled by new company offerings and a sense of future prosperity, it is difficult not to be fully invested. The risks appear to be more at the micro than at the macro level, with intensified competition increasing the incidence of 'torpedo' stocks.
"We have been here before. The period from 1968 to 1972 has some similarities. An economic boom did not prevent corporate failures, but more was lost being out of the market than in."
According to Hughes's classification, the first stage of the bull market, from 1981 to 1987, was dominated by the control of inflation.
He said: "The inflation 'premium' built into long bond yields was reduced substantially. Long gilt yields fell from 15% to under 9% by the spring of 1987. The real capital value of equities, as measured by the FT All Share Index, adjusted for inflation rose by over 200% during that period."
Stage II was dominated by corporate restructuring.
"Companies began to adjust to a different inflation environment. They could no longer rely on inflation to boost margins. They began to raise productivity and improve their competitiveness. This period, which extended from 1987 to 1992, was dominated by the reduction in the equity risk premium.
"Real capital values were broadly unchanged in this period, which has encouraged some commentators to regard this as a bear market with a new bull market beginning in 1992. However, total returns to equities continued to rise in real terms during this period, so we would regard this as a continuation of the long-term bull market."
Stage III began in 1992 with the UK's withdrawal from the ERM, Hughes believes. "Policy shifted to reducing the budget deficit and lowering interest rates. This combination of tight fiscal and loose money policies reduced the cost of capital. Real bond yields as measured by index-linked bonds fell from 4.8% in 1992 to under 2% in 1999. This reduction in the cost of capital was the main determinant of the sizeable gains in equity values. Real capital values for equities rose by more than 160% during this period.
"Fiscal policy remains restrictive, but it is no longer being tightened, whereas monetary policy is definitely becoming tighter.
"This change in policy will act to limit, and possibly reverse, the decline in real bond yields. These fell to 1.8% during 1999 and further reductions are unlikely to be sustained. The third phase of the bull market is therefore over."
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