Why has the FTSE 100 recently hit a record nominal high?
I ask because of a curious fact – that we haven’t seen a significant sell-off in gilts. In fact, 10-year yields are lower now than they were in October even though the All-Share index has risen by 3 per cent since then. This alone rules out some potential explanations for the rise in shares. If they’d risen because of expectations of faster economic growth or an increased appetite for risk, gilt yields would have risen. The fact that they haven’t points us to other explanations.
But what? One thing that has in the past explained rallies in both equities and gilts is liquidity: if cash is cheaper or more plentiful – or expected to become so – gilt yields would fall and equities rise.
Again, though, this can’t explain shares’ rise. The Bank of England raised rates in November and is expected to do so again in 2018: so too is the US Federal Reserve. And broad money growth, in both the UK and developed economies generally, has slowed down recently. It’s difficult, therefore, to see that this has been a liquidity-driven rally.
This leaves another possibility – favourable news about supply conditions in the real economy. If costs of production fall we’d expect to see bonds do well as investors anticipate either lower inflation or lower interest rates (depending on how strictly the Bank of England is expected to target inflation) and rising share prices as they look forward to rising profits.
In one sense, though, we’ve actually had bad news on this front recently. Commodity prices have risen by 7 per cent since October. This has been good for resources stocks, but should have been bad for the larger part of the economy and stock market that uses commodities.
We have, though, had two other pieces of good news about supply.
One is wage inflation. One of the big surprises of 2017 was that this did not rise significantly in the US or the UK. This suggests there might be more spare capacity in both economies than was feared a few months ago.
The second piece of good news is productivity. Latest UK figures show that hours worked fell by 0.6 per cent in the three months to October while GDP grew 0.5 per cent. This implies that productivity rose by 1.1 per cent, after a decade of stagnation. Again, the UK is not alone in this: in the US, productivity rose at an annual rate of 3 per cent in the third quarter, after growth of just 0.6 per cent per year in the last five years.
Both of these developments suggest that the UK and the US can continue to grow without generating much inflation. This is good for equities as it means more dividend growth. And it’s good for bonds as it means a lower path for inflation and interest rates than feared a few months ago.
Sadly, however, it’s not clear that either development is permanent. Granted, globalisation and atomised labour markets have reduced workers’ bargaining power. But we cannot be confident this will stay low in the face of tighter labour markets. And if it does, it would eventually depress consumer spending, to the detriment of profits.
Also, it could be that the pick-up in productivity is a temporary result of demand exceeding expectations (and hence hiring), rather than a permanent breakthrough. Certainly, many of the determinants of productivity – not least of which is the capital stock – do not tell us to expect an acceleration in it.
These caveats aside, in saying all this I am weakening my prior beliefs.
I’ve been mildly pessimistic about equities this year because some good lead indicators (such as the global money-price ratio) are sending a worrying message. Stronger productivity growth and low wage inflation, however, suggest that high share prices have a stronger foundation than we might think – because they are based not upon irrational exuberance or cheap money but (also) stronger-than-expected fundamentals. This implies that the outlook for equities is not entirely terrible – as long, that is, as these fundamentals remain favourable which is, alas, a matter of doubt.
