The All-Share index has risen more than 20 per cent since its low-point in March.
It’s tempting to attribute this to hopes of a post-lockdown recovery in economic activity and profits. Such an explanation, however, is contradicted by a simple fact – that gilt yields have actually fallen since March. At 0.22 per cent as I write, 10-year yields are lower than they were when the All-Share index hit its low-point. This is odd. If shares have risen because of greater economic optimism or appetite for risk, you’d expect gilt yields to have risen as investors dumped saver assets. But this hasn’t happened.
Which suggests an alternative explanation for equities’ rally – that it’s based upon cheap and easy money. Quantitative easing – not just by the Bank of England but by the Fed and European Central Bank (ECB) too – has driven down gilt yields. Expectations that interest rates will stay low for many months have had the same effect. This has forced up share prices partly because of anticipations that investors will use some of the money they get from central banks buying of bonds to invest in equities – as they did in 2009 – and partly because with cash returning nothing, investors are seeking higher-returning assets such as equities.
In this sense, this has been a liquidity-driven rally.
Such rallies have a bad name. Some investors think they are 'artificial' because they are the product of policy interventions rather than of investors' own actions.
Such a view is silly. Policy-makers are as much part of the investing environment as companies, consumers and other investors. The idea that a market without policy-makers is somehow “natural” while anything else is artificial is a historical nonsense. There has always been state intervention in stock markets: the East India Company was founded as a state-backed monopoly in 1599, and policy support for share prices are perfectly normal.
More importantly, there is nothing especially unsustainable about liquidity-driven rallies in equities. A simple test tells us this. I looked at all three-month periods since 1986 in which we saw positive total returns on both equities and gilts: let’s call these liquidity-driven rallies. True, they weren’t all caused by cuts in interest rates, but they were often driven by expectations of such cuts, which are almost as good. I then asked: what happened to equities in the following three months?
The answer is: much the same as happened in any other time. After liquidity-driven rallies the All-Share index returned an average of 2.9 per cent in the following three months. That’s actually slightly better than the average for all three-month periods, which has been 2.4 per cent.
If we look only at the period since 2000, much the same is true. Equities have returned an average of 1.7 per cent in the three months after liquidity-driven rallies, which compares with an average of 1.2 per cent for all three-month periods.
Of course, there’s variation around this. Some liquidity-driven rallies have led to shares falling – such as in the autumn of 2007, start of 2010 and in the spring of 2011. More often, though, they lead to further gains for equities, such as in the summers of 2009 or 2016 or in the winter of 2011-12. The old cliche "don't fight the Fed" is correct.
One reason for this is that monetary policy often works in supporting the economy. Liquidity-driven rallies can therefore become earnings-driven rallies.
Also, liquidity need not dry up quickly. The Fed has promised to keep the funds rate near zero “until it is confident that the economy has weathered recent events”, which has been taken to mean to rise in rates until at least 2022. And the ECB has pledged to continue quantitative easing for at least another 12 months. Monetary conditions will therefore remain supportive of shares for a long time.
Of course, this does not guarantee that equities will rise. Disappointments about the pace of the recovery, fears about corporate bankruptcies or fears of a second wave of Covid-19 might well buffet the market. It is these, however, that must worry us and not the fact that the market’s rise has so far been powered by cheap money. Investors must cure themselves of their scepticism about liquidity-driven rallies.
