Markets are still at risk of a relapse

AS anybody who has ever watched a medical drama on television will know, signs of recovery are not always what they appear to be. This is especially true when the illness has been serious and the recovery is swift. This is just as true for the markets as it is for photogenic hospital patients.

It seems a long time since the world’s economy appeared to be on its death bed. Since March 2009 equity markets have surged. The S&P 500 has risen 63 per cent since its lowest point. The FTSE 100 has risen 55 per cent. These have been driven by better-than-expected earnings and a rebound in investors’ risk appetite, partly as a result of central bank stimulus programmes.

While it is tempting to read these as signs of rude health, the patient is still displaying some worrying symptoms.

One is the odd relationship between equities and government bond yields. Before the crisis, these used to be correlated – when equities were high, then so were bond yields – but this relationship became dislocated last spring, and has still not returned.

While equity markets have rocketed, bond yields have dropped steadily, falling to almost zero in some cases. The situation is the same across developed markets. If you plot the S&P 500 or Dow Jones index against the US T-Bill, or the FTSE 100 against the UK gilts, or the German DAX against the bund, this same unusual situation holds.

This is a worrying sign, says Moorad Choudhry, head of Treasury at Europe Arab Bank. “All things being equal, a rising stock market reflects market confidence, and investors branching out of safe assets such as gilts and into higher risk assets,” he says.

So why are they not doing this, and what does it mean? In Choudhry’s opinion, it reflects a lot of hidden risk aversion. While some investors have been snapping up cheap equities, wary institutional investors have been piling into safer assets such as US Treasuries.

Indeed, yields on short-dated US government debt have dropped to virtually zero as high demand pushed up prices. It all suggests that investors think that there is more bad news to come.

Choudhry is not alone in forecasting a renewed bout of risk aversion. Capital Economics’ analyst John Higgins thinks that it won’t be too long before the rally in the S&P 500 has run out of steam and expects the index to finish 2010 at around the 1,000 level, and for the yield on 10-year Treasuries to head back down to 2.5 per cent.

Higgins is particularly worried that the unwinding of government stimulus could have a seriously negative effect on stock markets.

“Credit easing may have soaked up bond supply, but it has also sparked a stampede into equities, by cementing expectations of economic recovery. Its eventual reversal could have the opposite effect on risk appetite,” he cautions.

This would spark a drop in equities, as investors become more risk averse and could see yields remain low as even more traders pile into perceived safe-havens such as US Treasuries. Perhaps central bankers should not be packing the defibrillator away just yet. Spread betters should certainly be wary.