Feb 18, 2015 07:37 AM EST

Stock markets keep calm and carry on

War, financial crises and deflation again haunt the markets in the new year, but stocks somehow keep calm and carry on.

There's something a little eerie about watching equity markets on Wall Street or in Frankfurt and London wend their way to new records or multi-year highs against a backdrop of smoldering conflict in Ukraine, a real risk of Greece leaving the euro and angst about consumer price deflation worldwide.

On the face of it, all pack a potential punch to business and banking confidence, spending by indebted households and the bottom lines of companies and governments.

But the fact that historically expensive blue chip stocks continue to climb a 'wall of worry' shows either investor complacency or a less obvious reading of the state of the world.

To be sure, there is no shortage of doomsayers predicting it will all end in tears, and many fear we're in the final throes of one of the longest equity bull markets in history.

Others decry the asset inflation as a pernicious side-effect of central bank money printing that merely exacerbates the gulf between the 'super-rich' and the rest of the population.

All that may be true. But there are prosaic explanations for why the steady grind higher in stock markets has lasted so long and shows so little sign of tiring.

Four issues dominate: persistent if unremarkable world growth; super-loose monetary policy and a large global pool of new central bank cash; the relative attraction of equity dividends in a world of zero or even negative bond yields; and stimulus from the energy price collapse of the past six months.

Measures of global growth always mask national disparities and internal inequities. Yet they remain a good proxy for the demand multi-national firms see for their products worldwide.

To much fanfare and hand-wringing, the International Monetary Fund last month cut its world growth estimate for 2015. But at 3.5 percent, that's still an acceleration on last year and just two-tenths of a percentage point shy of the average growth rate of the past 10 years.

Sluggish no doubt, but no economic collapse for all that. Under the bonnet, the average annualized growth rate of the United States, Japan, Germany and Britain in the last quarter was 2.4 percent, while the likes of China and India registered growth in excess of 7 percent for 2014 as whole.

Given that together those six countries account for some 50 percent of world output, it's no surprise corporate earnings growth has borne up under that macro picture.

With most S&P 500 companies now having reported U.S. fourth quarter earnings, more than 70 percent have topped forecasts to record aggregate profit growth of about 6.6 percent. About 60 percent of the half of European firms that have reported are also ahead of expectations, and profit growth there is running at more than 11 percent - almost twice the pace of U.S. peers.


And in a world where interest rates and bond yields have all but disappeared - and in some cases turned negative - steady earnings growth will continue to draw investors to equity, if only for the dividends.

This is one big reason why equity in Europe, despite being the epicenter of much of the economic and political concerns hanging over markets, has become the investment destination of choice.

Exposure to euro equity jumped in February to the highest since May 2007 and the second-highest on record, according to a monthly investor survey by Bank of America MerrillLynch.

"It is as if there is not a single bear left," Manish Kabra, the bank's European equity strategist, told clients.

Along with double-digit earnings growth, resurgent auto sales, cheaper energy prices and a more competitive euro, the approach of next month's sovereign bond buying from the European Central Bank has already sunk yields on more than a quarter of euro government bonds below zero.

Crucially, the annual dividend on the euro zone's Stoxx50 index of blue chips, at almost 3.5 percent, is higher than any euro government bond yield out to 30 years - bar Greece.

Citing this contrast and negative interest rates as the 'secret sauce' driving stock markets, Baring Asset Management's Christopher Mahon says slow, steady growth is likely enough.

"European equities don't require a booming economy to do well," Mahon said.

In many respects that's the same everywhere. The zero rate policies and quantitative easing in Europe or Japan - egged on by headline deflation anxiety led by a largely stimulative oil-price drop - does 'leak' into all world markets more generally even as U.S. interest rates are poised to rise this year.

In an example of how money created in one region is fungible with another, BoAMerrill analysts said they expect up to 30 percent of high-grade euro corporate bond sales this year to be from U.S. entities - almost twice last year's proportion.

And maybe the slow grind to equity has worked best when so many are still wary of the risks. By the same token, the sudden burst of optimism revealed in surveys may be just as revealing.

"Sentiment can be such a potent contra-indicator," said Hawksmoor Investment Management's Jim Wood-Smith. "We are built to be bullish about what we own, not what we do not."

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