Global economy not in danger despite volatility of markets

THE ongoing de-rating of equities relative to other asset classes continued with a vengeance this week with nervous investors knocking 5% and 6% off the value of S&P's 500 and the Nasdaq respectively in the past five days.

The ISEQ failed to escape the wrath of investors, declining by over 6% at the lows this week. The heavy weighting of financials in the Irish index meant that accounting-related fears emanating from large investment banks such as JP Morgan Chase had a particularly negative impact.

Global markets also exhibited a level of intra-day volatility not seen since the 1987 crash.

So what’s happening? One could be forgiven for thinking that the global economy must be in tatters.

However, to say that equity market weakness is a reflection of a weak US economy is to fly in the face of hard economic fact. The improvement in available economic indicators since the lows of September 11 across a wide range of sectors such as manufacturing consumer activity remains unhindered.

At the same time, there is no guarantee that falling share prices will not precipitate economic weakness in the future through lower consumer spending and lower business investment. But this is a separate issue.

The key question is why equities are being de-rated so severely against other assets such as bonds, property and cash. It is best to start with a look at company profits. On a national income accounting basis, US corporate profits are up 19% from the lows of last year, which amounts to a rise of 6.7% on an annual basis. Given productivity gains in the US and falling unit labour costs, these data show that profits are recovering in line with what we would have expected on a macroeconomic basis.

A weak underlying trend in current and expected profits, therefore, is not the root cause of the price weakness.

The deterioration in the geopolitical environment following September 11 is another reason investors see higher risks in equities. But the idea that equities cheapen relative to other assets in times of war is not entirely correct. For example, equities outperformed during the Korean and Vietnam wars. After all, wars tend to be expensive, leading to growing government deficits which can cheapen bonds more than equities.

In our view, the true cause for the current weakness in equity prices lies in the structure of the microeconomy. We have long said that the cyclical recovery currently underway at macro level has only been made possible by aggressive cost-cutting at the individual company level. Although most workers have kept their jobs, companies are reducing their debt levels and capital expenditure. This process is known as corporate de-leveraging and is, unquestionably, the dominant theme in equity markets at present.

A common measure of corporate leverage is the ratio of debt to profits, which over the past 40 years correlates positively with equity valuations. Generally, a high degree of leverage justifies higher equity valuations. This is because debt can be used for investment which, in theory, increases future earnings. Alternatively, leverage can be used to increase dividend payouts or for share buybacks, making equities more attractive to investors. The negatives associated with corporate de-leveraging are key drivers at present.

How much further this process has to run is unclear.

What we can say is that equity markets are not giving us a signal of impending economic doom. Rather, the sharp declines in equity prices and valuations are a reflection of the microeconomic reality of the corporate de-leveraging process.

Don Walshe is senior economist at Goodbody Stockbrokers.