There are different types of stock market rise. Some are driven by better economic growth or increased optimism or greater appetite for risk. Others, though, are caused by either the reality or the hope of easy money.
There’s an easy way of distinguishing these two types of rise. Rallies caused by increases in economic optimism or appetite for risk usually see bond yields rise as investors shift out of safe assets and into ones that benefit from better growth or increased appetite for risk. Liquidity-driven rallies, on the other hand, see bond yields fall either because investors put some of their extra cash into bonds, or because central banks are buying bonds with the money they are printing, or because expectations of lower short-term interest rates reduce bond yields.
By this simple metric, this year’s rally in stock markets has been driven by liquidity. Bond yields have fallen as shares prices have risen, in part because of hopes that the Fed will cut rates.
Is this dangerous? Common sense says so: 'it’s a liquidity-driven rally' has historically been a phrase more uttered by bears than bulls.
History, however, tells a different story. It suggests that liquidity-driven rallies can be sustained.
To reach this conclusion, I defined liquidity-driven rallies as six-month periods in which we saw falls in both the dividend yield on the All-Share index and in five-year gilt yields. Using monthly data, there have been 117 such periods since 1985. I then asked: what happened to equity prices in the following six months?
The answer is: not much. On average, the market rose by 3.5 per cent in these six months. This is actually slightly better than the average rise in all periods since 1985, which has been 2.8 per cent. It’s also a little better than the market’s average performance in the six months after liquidity-driven falls in prices – on these occasions, we saw the All-Share rise by an average of 2.7 per cent.
For example, although liquidity-driven rallies in equities in 1987, late 1993, 2015 and early 2018 did lead to the market falling, there have been many other times when they led to further price rises, such as in 1992, 1997, 2005, 2009 and 2016.
The idea that liquidity-driven rallies must end in tears is therefore wrong. Yes, they might do so – but this is no more likely than for other types of rally.
You might find this odd. Didn’t I say last week that although the expectation of rate cuts is good for equities the reality of them can be bad?
One answer to this apparent paradox is that liquidity-driven rallies are not the only ones that sometimes end nastily. Those founded on greater optimism for earnings or increased appetite for risk can also lead to falls when that optimism proves misplaced or when tastes change, such as in 2011 when the euro crisis punctured optimism about the global recovery.
The other answer is that liquidity-driven rallies – those caused by expectations of looser monetary policy – are sometimes based on genuinely better economic conditions.
Imagine that something were to happen to cause investors to expect both lower inflation and faster economic growth. We’d then see both equities and bonds rally. And if such expectations prove correct, the rise in share prices could be sustained.
In the past, this has been the case when oil prices have fallen. Their drops in 1986, 1997 and 2009, for example, led to falls in bond and equity yields that were not quickly reversed.
In fact, anything that fuels hopes of non-inflationary growth would have the same effect. The justification for this year's rise in equities is not that the Fed will cut rates. It is instead that the failure of wage inflation to rise suggests that the economy can continue growing without triggering inflation.
Exactly why this has happened is a matter of dispute. It’s possible that, as the Bank of England’s Andy Haldane has said, the Phillips curve is flatter than feared because workers are no longer able to parlay tight labour markets into higher wages. Or it could be that in more open economies inflation is determined by global forces more than national ones.
Whatever the explanation, the fact is the same. Fears of inflation have receded and this has caused investors’ interest rate expectations to fall and share prices to rise.
The true justification for the stock market rally, therefore, is not lower rates in themselves. It is that investors believe the economy is more capable of generating non-inflationary growth than they thought it was a few months ago.
Herein lies the key to whether this rally can be sustained. It can be if this optimism proves to be correct, and it won’t be if it is wrong.
In this sense, interest rates are a red herring. Investors should worry less about what the Fed will do and more about whether the good performance of the US economy can continue. For now, it looks as though it might.
