A Peak With A View?

by Michael J. Howell10. March 2013 22:02
New highs on Wall Street have prompted inevitable navel-gazing. A popular repost is the 'lack of correlation between GDP and stock prices'. Another is the artificial '100-150bp drop in bond yields caused by QE policies'. The real questions should be (1) is there a strong correlation between GDP and profits growth, and (2) what governs the valuation of these profits? The first answer is an unequivocal 'yes' and the second comes down to two things - the scale of QE (and other liquidity effects) and the underlying inflation rate. It is clear that more QE reduces risk premia on risk assets. Since bonds are a low risk asset for long-term funds, QE is more likely to raise not lower risk prema on bonds. Therefore, the longer than QE persists, the more that equity risk premia will fall and bond risk premia will rise. Regarding inflation, Central Banks do not create CPI inflation, but governments do. While private sectr debt is high and excess capacity high, there will be no acceleration in inflation. Therefore, based on these 'internal' risk factors, Wall Street et al should rise. But two 'external' risk factors worry us: a too strong US dollar and the recent tightening by the ECB. End-February GLI liquidity data will be published around March 14th. They need to be watched.

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