The year of the crash?

The bull market in virtually all financial instruments in 1993 has left many observers nervous that the markets are set to crash in 1994. With equity markets at or near record highs, and price/earnings ratios looking stretched in many markets, it has been a commonplace in recent weeks to read about financial market 'bubbles' and 'mania'. But is this scepticism - indeed downright pessimism - justified?

I rather doubt it. Although the boom in financial assets may seem to sit uneasily with the continuing recession in many developed economies, it is of course expected economic performance, not current performance, which drives financial markets.

And the dominant force in the markets last year was undoubtedly the dawning realisation that global inflation pressures had diminished to a much greater extent than consensus opinion had recognised as 1993 opened.

With worldwide inflation pressures now scotched, the prospects for a prolonged period of solid growth in activity, underpinned by exceptionally low interest rates, have rarely looked better.

The decline in global inflation pressures allowed the big central banks progressively to ease monetary policy. In almost every economy, short-term interest rates either fell sharply or (as in the US) failed to rise in the way anticipated by the money markets. These favourable surprises in short-term interest rates undoubtedly had a big effect at the longer end of the bond markets, and this in turn underpinned much of the rise in equity valuation during the year.

Indeed, as the table shows, the ratio of bond yields to dividend yields, or the ratio of short-term rates to dividend yields, barely changed during 1993 - which undermines the idea that equity markets have become chronically overvalued relative to interest rates.

Clearly, though, the equity and bond markets would be in trouble if the central banks were suddenly to turn unfriendly. The big question is therefore whether the 1993 phenomena of low inflation and tumbling short rates will repeat themselves this year or, alternatively, whether the greater optimism now priced into short-term interest rate expectations in Europe and Japan will be disappointed this time.

Ultimately, the behaviour of short-term interest rates will depend on the assessment of the big central banks of the likely behaviour of inflation in the years ahead. From virtually any angle, this looks encouraging. Activity in the main economies is certainly not likely to expand rapidly enough to trigger early inflation concerns. On the latest estimates published by the OECD, every one of the main seven economies has a negative output gap (ie real GDP is below trend). For the big seven as a whole, the weighted average output gap in 1993 was 2.6 per cent of GDP, which is one of the highest readings on record. Furthermore, most forecasts suggest that real GDP in 1994 will grow by only about 2 per cent, which is at least 0.5 per cent below trend. Hence, the output gap will not only remain large, but will actually widen to more than 3 per cent of GDP in the course of this year.

In this context, it would be extremely surprising if underlying world inflation were not to continue declining - which implies that global macro-economic policy should be eased further. None of this easing is set to come on the fiscal side. According to the latest budgetary plans, the general government financial deficit for the developed economies will decline from 4.3 per cent of GDP in 1993 to 3.8 per cent in 1994, and more than the whole of this reduction will be explained by a tightening in budgetary policy. (According to the OECD, this tightening will amount to 0.8 per cent of GDP in the coming year.)

Of the big seven economies, six have announced plans to tighten budgetary policy in 1994 and the only exception - Japan - is expected to ease policy by a negligible 0.2 per cent of GDP. In other words, if the overall macro-economic policy stance is to be eased this year - as would seem essential given the likely behaviour of the output gap and unemployment in the main economies - then the whole burden will have to fall on monetary policy.

The developed world is flirting with the danger of deflation - absolute declines in many prices - unless more is done to ease monetary conditions. Although monetary policy appears to be very accommodating in the US - at least when measured by the level of interest rates or the growth in narrow money - there has been no significant acceleration in broad money growth. Meanwhile, in Japan, nominal interest rates are at historic lows, but the willingness of the banking sector to lend money continues to be restrained by balance sheet problems. Japanese business surveys suggest, as a result, that monetary policy is still quite restrictive. In Continental Europe, both real interest rates and the shape of the yield curve indicate that monetary policy is astonishingly restrictive for this stage of the economic cycle.

The money markets are currently 'pricing in' declines in short-term interest rates during 1994 in Continental Europe, the UK and Japan, but this is counter- balanced by a significant expected increase in the US. The weighted average for the largest seven economies indicates that the money markets expect short-term interest rates to rise from 4.14 per cent now to 4.2 per cent at the end of 1994 - surely an expectation that will prove too pessimistic, given the arguments outlined above. Average interest rates must fall this year, not rise.

If this proves to be the case then the outlook for long bond yields for much of this year is encouraging. In fact, taking the world as a whole, there is no good reason to expect bond yields to start rising during 1994. Based on past evidence, the trough in bond yields should occur within a few months of the low point for inflation (either just before or just after, depending on the country), and the trough in inflation should not occur sooner than 12-24 months following the upturn in global GDP growth. Since world GDP growth probably bottomed some time around the middle of 1993, this would indicate a likely turning point for inflation some time between mid-1994 and mid-1995, and a possible trough in bond yields at around the same time.

These facts should be reassuring. Furthermore, given the sluggish nature of the GDP upturn now expected, and the extent of the output gap at present, it would not be at all surprising to see inflation and bond yields declining for longer than these rules of thumb would imply. This would be particularly likely to occur if there were further reductions in real bond yields as the inflation risk premium continued to decline. Note that although the global real bond yield fell from 4.4 per cent at end 1992 to 3.1 per cent at end 1993, it still remains higher than the long-term rate of return on capital in the developed world - a remarkably high figure for a recessionary phase of the cycle. Real yields should decline further.

Last year, the return on global bonds was about 19 per cent, about 2 per cent below the return on equities. It would be surprising if either market were quite as buoyant this year. But it would be equally surprising if the widely feared financial crash were to occur.

----------------------------------------------------------------- FINANCIAL MARKETS IN THE PAST 12 MONTHS ----------------------------------------------------------------- Total returns in 1993 (%) Cash Bonds Shares World 5.3 19.5 21.1 World exc. Japan 5.8 20.2 24.4 World exc. US 6.6 23.3 28.4 UK 6.1 23.2 23.4 ----------------------------------------------------------------- (%) End End 1992 1993 All main economies * Three-month int. rates 5.7 4.0 Ten-year bond yields 7.1 5.3 Real bond yields 4.4 3.1 Dividend yields 2.7 2.1 Bond/div. yield ratio 2.7 2.5 Short rate/div. yield ratio 2.1 1.9 ----------------------------------------------------------------- * Average of seven main economies weighted by GDP -----------------------------------------------------------------