Danger stock market bull run may soon run out of steam
World stock markets have enjoyed a handsome bull run over the eight weeks since the beginning of the year.
This week America's Dow Jones Industrial Average topped the 13,000 mark, a level it hasn't seen since May 2008, months before the implosion of Lehman Brothers signalled the US credit crunch had shifted to a new and altogether more painful dimension.
Markets in Europe have also performed strongly. Even though Greece's debt crisis drags on, entering its third year, the euro zone's Stoxx 50 index has gained 11 per cent since the start of 2012.
And in Asia, Hong Kong's Hang Seng Index has climbed 17 per cent so far this year. Since its low early last October, the benchmark has now risen an impressive 33 per cent.
It is not just stock markets. Commodity prices have rallied smartly too, with the S&P GSCI commodity index up by 9 per cent so far this year.
Given that stock markets usually run ahead of developments in their underlying economies, this sterling performance has raised hopes that the world may finally be about to emerge from the long period of turbulence that has afflicted growth since the US credit crunch first began to bite back in 2007.
It's true that there are some good reasons to be moderately optimistic about the near-term outlook. Unfortunately, forecasting the world economy's imminent emergence from crisis based on the performance of its stock markets is carrying that optimism altogether too far.
Equities are rising largely because they are floating on a tide of liquidity. As HSBC strategist Garry Evans pointed out in a research report last week, the start of the current leg of the bull run coincided neatly with the European Central Bank's long term refinancing operation, or LTRO, in December (see the charts above).
This move, which injected Euro489 billion (HK$5 trillion) into Europe's banking system via three-year loans, saw the ECB follow the US Federal Reserve, the Bank of England and the Bank of Japan into quantitative easing in a bid to avert a systemic banking collapse.
As Evans explains, the injection was all the more powerful for being unexpected. Like the first rounds of quantitative easing from the Fed, the Bank of England and the Bank of Japan, it had a marked impact on asset markets.
With banks sitting on more cash than they needed, they shifted the money into the government bond markets, driving prices up and yields down. The fall in yields in turn displaced other investors, who turned to the equity markets in search of better returns.
The result is the dramatic rally over the last two months, which Evans concludes is 'almost entirely due to the European Central Bank's long-term refinancing operation'.
Unfortunately, his conclusion implies that the rally may not be sustainable. Although the ECB plans another round of its LTRO next week, HSBC analysts believe the liquidity injection will be smaller than in December. And because it is expected, the impact on asset prices will be far weaker. After that there are no plans for any further rounds.
That's troubling, because previous episodes of quantitative easing suggest that the rally may not outlast the ECB's liquidity injections. 'When the central bank stops buying, the effect on stocks can turn negative,' explains Evans.
With the positive effects of the ECB's action likely to fade away over the coming weeks, Evans warns that investors will return to focusing on more conventional drivers of stock market performance: the strength of underlying economic growth, the outlook for corporate earnings, and developments in Europe's sovereign debt crisis.
None of these is encouraging. With Europe's biggest economies on the brink of recession, the US struggling and growth in China slowing, the economic picture remains grim. Similarly, the outlook for company earnings in Europe and Asia is deteriorating. And while Greece's latest bail-out has averted the risk of an immediate default, it has done little to address the continent's underlying problems.
As a result, there is a danger that the bull run in equities may soon run out of steam.