A powerful message for equity markets.

By Mike Lenhoff 11:18 13- Aug -2009

Both the Federal Reserve and the Bank of England delivered a powerful message for corporate bond and equity markets this week.

This was that interest rates are staying where they are for some time regardless of the improving economic news flow and in spite of the expectation they share for growth to resume in the latter half of this year. As the chart shows, the message was not lost on Treasury markets where yields at the short end fell. Given the latest surprise out of the Eurozone - second quarter GDP growth was negative, but only marginally so, and actually positive, albeit modestly, for the German and French economies - it remains to be seen whether the message is one the European Central Bank will want to endorse.  

So, what about that correction? I have been talking about it (Equities look overbought but the trend is your friend, 3 August 2009), others have been talking about it and it has not been happening. The momentum underlying equity markets is being fuelled by favourable news flow. You might have thought that equity markets are up with events and, on that basis, due for some consolidation but they are not yet ready for it. Two points seem relevant here.  

First, favourable news flow means upward revisions to expectations for growth - and this is what we are seeing. Second, valuations are still appealing. The following chart shows the bond-equity earnings yield ratio. This is the yield on US Treasuries divided by the 12-months forward earnings yield on the FTSE All-World Index. While equity markets are no longer inexpensively rated, they are far from dear. Their current valuation reflects the same rating against government bonds that launched the last bull market in the Spring of 2003.  

Valuations remain attractive. With the global economy moving from a downswing to an upswing in the cycle, expectations are likely to be revised up for GDP growth and corporate earnings. Also, the Fed continues to reassure investors that ‘exceptionally low levels’ of the federal funds rate are warranted for an extended period. All this is a good case for thinking that, while a breather is still due in equity markets, the trend is still your friend.

As for sector strategy we’re still talking about overweighting cyclicals (e.g., Mining, Aerospace & Defence and General Retailers), financials (e.g., the Banks have been very recently upgraded to overweight) and a few defensives (e.g., Oil & Gas and Beverages).