Going their separate ways

At the start of this year it appeared that common sense had finally prevailed
as equity prices tumbled to reflect the impact of the credit crisis. But over
recent weeks, equity markets have once again rallied despite credit markets
continuing to languish.

This decoupling of the two markets has made strategists scratch their heads.
Are there very different factors affecting the equity market compared with the
debt markets or are equity investors in a state of denial about the full
ramifications of the credit crunch?

Ian Scott, global and European equity strategist at Lehman Brothers, thinks
credit markets have been pushed below their fair value. “There are a number of
technical factors that are pushing these markets below levels justified by the
current credit conditions. Limited liquidity, reduced investor risk appetite and
balance sheet constraints have resulted in an unnaturally subdued market,” he
says.

Delving more deeply into the equity market, other factors emerge to support
Scott’s analysis. “Since 9 January, the share prices of companies with lower
credit ratings have risen by an average of 5%, while those with the best credit
ratings have declined by 4%,” says Scott.

The recent rally of those stocks with lower credit ratings indicates that the
equity market is no longer concerned that these stocks will be in danger of
defaulting, even though spreads have continued to widen in the credit market.
Scott says this is further evidence that credit markets are artificially
depressed. “Not only have equity and credit asset classes decoupled, they have
also done so at individual stock level,” says Scott.

Michael Dicks, head of research at Barclays Wealth, believes the financial
markets’ tendency to over-exaggerate price movements is to blame. “If you look
back at historic asset price booms and busts, a good rule of thumb is that the
more unrealistic prices look during the boom, the greater the pain when the
bubble bursts.” Before the credit crunch, spreads had become ludicrously narrow.
Many, including the Bank of England, were concerned such narrow spreads
indicated that the market had had temporarily forgotten about the risk of
investing. It’s not surprising, then, that the revaluation overshot when the
correction came, says Dicks.

Predictable fall
A fall in the equity markets was highly likely given the probability that the
credit crisis could hamper growth of the global economy. “It’s not surprising
that equity prices should fall, but they should not fall as far as the credit
markets because the bubble was in the debt, not equity markets,” says Dicks.
This helps to explain why equity markets have held up better than credit
markets. Mitchell Fraser-Jones, product director for UK equities at Invesco
Perpetual, thinks the decoupling reflects the different outlooks of the two
asset classes on the future economic growth.

“The performance of the equity market implies that it believes the current
economic difficulties will be largely confined to 2008. Bond markets, in
contrast, seem far more worried about prospects for inflation, and that we may
be in for a more prolonged period of stagnating economic growth. Shorter-dated
bond yields have fallen to reflect lower interest rates and concerns over the
growth outlook where as the longer-dated instruments are still high indicating
that there are concerns about rising inflation.”

A more positive outlook for the global economy is not unreasonable. Most are
forecasting only a contraction in global economic growth, even though there is a
strong probability of the US going into recession – if it hasn’t already.

There are real concerns that the US and UK economies have become unbalanced
and over-reliant on their consumer and housing sectors. “A weaker dollar over
the past three years has gone some way towards helping to redress this
imbalance; US exports are now soaring and the current account deficit is
shrinking. It’s likely that we will have to go through the same sort of
correction in the UK,” says Fraser-Jones.

Scott thinks the correction in equity prices has gone too far. “Global
equities are currently trading on their lowest multiples since consensus data
was first available in the 1980s. Analysts may well have to cut their forecasts
further, but the 25% reduction needed to return the multiple back to average
levels implies a greater downgrade to earnings estimates than seen during the
last two recessions,” he says.

Fraser-Jones agrees that some company valuations have become compelling, but
that uncertainty about the level of risk means that investors are sitting on
their hands. “We still have no clarity about how long the downturn will last. As
soon as we see a bounce in economic activity, it’s likely that we will have a
very strong rally in equity markets.”

The decoupling has led to a widening of the yield gap between the two asset
classes. Equity earnings yields and bond yields decoupled at the start of the
millennium, reflecting the long period of low inflation that has kept bond
yields down. Equities saw valuations slump during the 2000-03 bear market and
have not recovered to the levels seen before the market crash.

The gap has widened further in recent months, with equity yields pushing out
to 9%-10%, reflecting the market’s concern that companies will not be able to
sustain their recent profit margin improvements.

Attractive equity prices and the greater likelihood of the stock market
recovering before the credit market means that decoupling looks set to stay.