Edmond Jackson's Stockwatch: The Big Picture

Stockmarkets have breached the seasonal law to "sell in May and go away" with indices edging even jumping ahead. Is this rational or ultimately unstable?

While there have been aspects of good economic news, the macro context remains challenging with embedded risks. I believe the key factor driving markets is the build-up of exceptional monetary stimulus with money continuing to chase equities higher after the party in bonds.

There are broadly two aspects: "carry trades", where banks and hedge funds borrow substantially at low interest rates to buy financial assets offering a superior return; and conservative investors desperate for some kind of return, than next-to-nothing from cash. The bullish trend in developed stockmarkets from end-2011 has created a sense of relative security in stocks.

The risks were cited in a 20 May retirement speech by Charles Bean, deputy governor for monetary policy at the Bank of England. As central banks withdraw their extraordinary stimulus measures over the past five years, "a few potholes" are likely to be encountered as they raise interest rates and sell the trillions of dollars worth of bonds bought since the banking crisis.

The Bank of England bought £375 billion of UK government bonds from 2009 to 2012, equivalent to some 25% of annual GDP. "Market interest rates are bound to become more volatile along the exit path," he said.

More positively, banks in advanced economies are now more resilient to financial stress, which should help shield firms and consumers. He predicted UK interest rates could start rising before next spring, taking three to five years to settle at about 3%.

To date it has paid to ignore bearish sceptics of loose monetary policy and its consequences. Despite last year's "taper tantrum" over guidance from the US Federal Reserve, the behavioural evidence shows markets adjusting well to the $10 billion (£5.97 billion) monthly reduction in stimulus.

Bean describes this as "complacency and an underestimation of risk by investors". He anticipates falls in risky asset prices that "could be prompted by developments in Ukraine, the fault-lines in the Chinese financial sector, monetary policy exit in the advanced economies, or something else. But it will surely come at some point".

Such risk factors I have previously examined and markets have taken them in their stride. I have described a theme of "muddling through" major risk factors such as the US debt crisis nearly two years ago, then eurozone debt, Greece, Cyprus and so on.

As with accumulated strong doses of ibuprofen it is possible the build-up of monetary stimulus has dulled awareness of underlying troubles. There is also the opportunity cost of trading out of equities (and costs of getting back in) in response to "crises". But since 2011 especially, long-term investors have come to believe it is better to stay the course than actively trade.

In a third year of resilient markets this belief is well-established so it may need an unexpected "Black Swan" event to disturb confidence.

The Ukraine crisis initially looked like one, but since Russian troops have not crossed the border and Petro Poroshenko achieved 52% of the Ukraine presidential vote, markets have reckoned Russian president Vladimir Putin unlikely to take further risks.

In addition to the prospect of tougher sanctions biting, his argument for military action "to protect Russian speaking people" is no longer credible. Ukraine now has legitimacy for tough action against rebels in its eastern territory and unless Russia responds the sense of crisis may ease despite ongoing skirmishes.

One critical point I have emphasised is whether US corporate earnings can improve despite what effectively amounts to monetary tightening as the Fed unwinds stimulus, and possibly exiting completely by end-2014. Might there be a lag effect whereby the Fed closes out amid fair economic numbers, only for weakness to return six to 12 months later?

The earnings trend currently shows improvement in the sense that negative outlooks are reducing and any cuts in earnings estimates are not as aggressive as in the past.

"Secular stagnation"

However negative outlooks still outnumber positive ones at a ratio of 2.9-to-1, versus 4.7-to-1 for first quarter 2014 and 7.8-to-1 for fourth quarter 2013, which was a worry last autumn. This lends credence to the "secular stagnation" thesis advanced by US economist Larry Summers, where recovery amounts to a bounce-back from exceptional lows but remains sluggish.

It is also interesting how big US firms such as United Technologies, Coca-Cola, General Motors and McDonald's are reporting strong results from their operations in China, versus macro-economic data that has raised fears about Chinese growth slowing. Yet the property market remains an acute dilemma for international risk: prices in Beijing and Shanghai have reached similar extremes as in Tokyo just before Japan's economic downturn started.

In 1990, Tokyo's total land value represented 63.3% of US GDP while Hong Kong reached 66.3% in 1997; currently the total land value in Beijing is 61.6% of US GDP.

Furthermore, land sales and property taxes provided 39% of the Chinese government's tax revenue last year, a similar situation to Ireland during its boom years that ended in bust.

A mitigating factor is that China demands a 20% reserve requirement from its banks. This means monetary stimulus can be supplied quickly by cutting this to single figures. Such a move would however stoke longer-term risks given Chinese credit is already estimated at the equivalent of $25 trillion. It should tackle its debts although that would export deflation.

So China appears to be in a vice where either policy option could lead to trouble. Some observers put faith in Communist Party leaders navigating a way through, however Japan was similarly considered invincible in 1990.

Maintaining a portion of cash in a portfolio, despite its lack of return, therefore looks prudent against any shocks on the road ahead, while also enabling flexibility to take advantage of asset price falls.