By Mike Lenhoff 31/05/2007 00:00
Who’s worried about the Chinese stock market - aside the former Fed Chairman, that is? The Chinese authorities are. But is the Chinese punter? Probably not! We’ll come to that in a moment.

In a recent paper, Liquidity Risk and the Global Economy, Timothy Geithner, President of the Federal Reserve of New York, noted that, while monetary policy can’t do much to ameliorate or rectify an existing substantial asset price misalignment, it can, if ‘ … calibrated appropriately, reduce the risk that such misalignments will emerge and expand.’ China’s stock market was not exactly what Geithner had in mind, though it makes what he had to say all the more relevant.

This was that if the central banks can calibrate policy appropriately, or even approximately, so as ‘to keep aggregate demand growing roughly in balance with aggregate supply and to keep inflation low and stable’, they are likely to retain investors’ confidence in the outlook for a less volatile world. That won’t be a world without shocks, but it could be one that is better able to cope with them and hence one in which risk premiums in asset markets deserve to be lower than they might be otherwise.

Rising interest rates and slowing earnings growth ordinarily lower fair values for equity markets, yet the markets have been moving relentlessly upwards. Rising interest rates might also be expected to widen credit market spreads, but the spreads have been narrowing. Financial markets may be overwhelmed by weight of money, corporate activity or whatever, but lower risk premiums can also explain why equity markets have been so resilient and why credit market spreads have continued to tighten.

Animal spirits rather than low risk premiums probably account for China’s stock market, which has gone ballistic. Mr Greenspan’s apprehension about that market is understandable when you look at the chart, but while a setback of significant proportions would knock the stuffing out of global equity markets, the likelihood is that it would also provide a buying opportunity - for the Chinese. The Financial Times (May 30 2007) reported that over 100 million share accounts have been opened to date. Think of the hundreds of millions more that have yet to be opened!

As for global equity markets, the fundamentals remain supportive. Consensus forecasts for GDP growth in the major economies, the US economy excepted, as well as the developing economies including China and India, have been revised up since the start of the year - for 2008 as well as for 2007. That’s good news for corporate earnings. It means that the earnings surprises could still be on the upside. That’s good news for equity markets.

The bad news is that, in time, interest rates may have to rise to higher levels than expected. However, for now the cost of debt servicing is low relative to earnings yields in equity markets, so the economics underlying mergers and acquisitions still make sense. Again, that’s good news for equity markets.

Valuations are supportive. The bears claim they can’t find cheap stocks. Why should they after a four year, going on five year, bull market? There may not be any bargains about but that’s not to say that equities are dear.

Take the UK equity market. The Banks, which make up over 21 percent of this index, are not expensive and neither is the Oil sector, which makes up another 12 percent of the Index. Mining, which makes up nearly 9 percent of the FTSE 100, and Life Insurance, which makes up nearly 5 percent, are not expensively valued either. Current p/e ratios for each of these four sectors, which make up nearly half of the FTSE 100, are either below or very near their respective long term sector average p/e ratios.

Nor are any of the major equity markets expensive. As the chart on the next page shows, global equity markets have reached a new all-time high but their p/e ratios are only marginally above what they were in the Spring of 2003. This relative constancy in ratings demonstrates that, whatever its impact, weight of money or corporate activity has not distorted equity markets. Investors have simply pushed up equity markets in line with earnings.

To return to where we started, there has been, as Geithner notes, a ‘marked improvement in global economic performance with strong growth, relatively low inflation and less volatility in growth and inflation’. It’s partly because of this that the fundamentals underlying equity markets are positive. And it’s partly because of the ‘global trend towards independent central banks with clearer mandates for price stability’, that interest rates, though on the rise, remain historically low.

As the chart above shows, equity markets offer the sort of value they did a year before Mr Greenspan pronounced on ‘irrational exuberance’. It took at least three years after that and valuations in the major equity markets like few have ever seen to bring to an end the bull market of the 1990s.

If the fundamentals are as sound as we think they are, this bull market is unlikely to run out of puff just because it happens to be four, going on five years, old (our year-end targets for the FTSE 100 and the S&P 500, currently 6650 and 1525 respectively, will be reviewed at the end of June).

As for the Chinese stock market, its bubble-like climb over the past year isn’t a reason for being bearish on global equity markets. It’s a reason for thinking a shake out is due - in the Chinese equity market. But corrections come and go. Thus far, there has been more risk in being out of equity markets than in them. As we see it, that is still the risk and our guess is that’s how investors in China will see it too.

* The information contained in this report has been taken from public sources and is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not the views held throughout Brewin Dolphin Securities Ltd. No Director, representative or employee of Brewin Dolphin Securities Ltd. accepts liability for any direct or consequential loss arising from the use of this document or its contents. We or a connected person may have positions in or options on the securities mentioned herein or may buy, sell or offer to make a purchases or sale of such securities from time to time. In addition we reserve the right to act as a principal or as agent with regard to the sale or purchase of any security mentioned in this document. Prices, values or income may fall against the investor’s interests. You should therefore be aware that you may get less back than you invested. Past performance is not a guide to future performance. If you are in any doubt concerning the suitability of these investments for your portfolio, you should seek the advice of a qualified investment adviser.