The American economy is indeed recovering, thanks to government handouts, but at what cost? The Federal Reserve has injected staggering amounts of liquidity into the banking system that sooner or later will lead to inflation. At the same time the public debt has gone through the roof. Inevitably creditors will demand real compensation for the added risk, in the form of higher bond yields.
Despite the authorities' considerable efforts unemployment has barely budged, and the housing market remains in a deep funk. As a consequence US consumer sentiment has failed to mount a genuine comeback from its all-time lows. The current recovery cobbled together by a government concerned about getting re-elected may fool some observers near term, but looking further down the road it lacks credibility. Small wonder, then, that households are wary about future tax increases and about job security. Investors are cagey as well. Burned by two stockmarket bubbles in less than a decade, after the second one burst they piled into reputedly risk-free US Treasuries. The buying spree drove bond yields down too far and has sewn the seeds of the next crunch. But are equities the better bet? Admittedly the forecasts for earnings growth—10-15% this year and again in 2012—are compelling, but besides being optimistic they will only be translated into higher share prices if the market P/E ratio stays flat. That is uncertain. To begin with investors are still quite doubtful about the sustainability of long-term economic expansion. Secondly a resurgence of inflationary pressure often causes earnings multiples to fall.
Over and over
A look at the total return on US equities relative to 10-year Treasury bonds is telling. Until 1995 this curve sloped gently upward, true to financial theory which posits that shares gain value faster than bonds do in the long run. Halfway through the nineties, though, things started getting out of hand owing to unduly low interest rates and the dotcom bubble. For five years the relative return on equities went into a vertical climb, leaving fixed income far behind. The deviation inevitably ended in catastrophe, but investors did not learn their lesson and by 2003 the US stockmarket was again barrelling ahead. This time the exuberance was fuelled by banks' bloated profits garnered on freewheeling credit. In a replay of 2000-02 shares collapsed along with house prices, while the value of Treasury bonds soared. The result was a new mountain of public debt that still has to be absorbed by the market. To make this process less wrenching, the Fed has been forced to churn out huge quantities of dollars ("QE2") to buy Treasury bonds. That story unfortunately is still being written, so no one knows how it will end. But two things are certain: the US economy has to be purged of this excessive debt and the bond bubble has to deflate. [...]
Original article from Michel Lagier, Banque Privée Edmond de Rothschild S.A.