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Economics Weekly - Are UK equities overvalued? Weekly economic data preview – A busy week, but little top-tier data, as markets wind down for US Thanksgiving

Economics Weekly - 23 November 2009


Are UK equities overvalued?


UK equity markets, along with many others around the world, have recovered strongly since their recent

low in March 2009. Admittedly, the FTSE All-Share is still well below its 2007 all-time peak and, if one wants to go back further, below the previous peak recorded in 2000. However, the fact that UK economic recovery so far seems to be lagging that of some other major economies could lead to doubts about the sustainability of the rise in share prices. Here, the issue is that with economic recovery not yet assured, a fall in equity prices could hit business and consumer confidence and potentially slow the pace of economic recovery.


A further concern is that the injection of cash into the UK financial system through the Bank of England’s

purchase of gilts is leading some to worry that a bubble may be forming in equity markets. We look at some evidence for and against in this Weekly.


Since the 2009 low in March, the UK FTSE All-Share price index has risen by around 50%. Still, this is 23%

below the 2007 high and a smaller 16% below the 2000 peak. In other words, the All-Share index is higher

but from a relatively low level and so the increase should be seen in perspective. To some extent, the fall may have been exaggerated by fears that have subsequently been proved to be unfounded. Nevertheless, it is important for the economy that share prices have recovered from recent lows.


The fall in share prices effectively meant a rise in the cost of capital for firms that wished to use equity to

raise funds for future investment, to pay bills, to merge with other companies or simply to strengthen balance

sheets to reduce bankruptcy risk. Thus, the recovery in the All-Share index since March this year has meant a reduction in corporate funding costs that has helped to reduce the number of corporate failures, ameliorated the rise in unemployment and fall in employment and increased business and consumer confidence. From other lending data, it is apparent that non-financial firms have used some of the funds raised from increased equity issuance to pay down debt owed to banks and other financial institutions.


What are some of the factors we should be looking at to get a better sense of whether the rise in equities has gone too far? Share prices should, in theory, reflect investors’ expectations of the future earnings (read

profits) of companies, discounted to today’s prices. Hence, there should be at least some correlation between corporate profit performance and share prices. Chart a indicates that this is indeed the case. Here, we use the corporate sector’s gross operating surplus as a proxy for corporate profits.


For the purposes of clarity and exposition, we have indexed corporate profits and the FTSE all share to

January 1988 equals 100. A number of things stand out. One, equity prices are more volatile than profits, as

to be expected since stocks are traded every day whereas corporate profits are reported quarterly and so will have a smoother profile compared with share prices. Two, there have been periods in which share

price growth has been well in excess of profits. Three, when share prices have been in this excess territory a fall back to below profits often occurs. Fourth, this period does not appear to be one of those. Conclusion: share prices relative to profits appear to be close to fair value. Another metric we have looked at is the FTSE All-Share price index relative to earnings and then compared this to its long run average, see chart b. This would help to signal whether, in a long run context, it can be said to be cheap or expensive. After a long period in which shares have risen slower relative to earnings, the current ratio is almost bang in line with the long-run average. In other words, share prices have risen relative to company earnings and can be said to be fair value in a long-run sense. Of course, there could be an argument that the return to this average is unjustified and it should be well below it, given the risks that there now are for the economy. For instance, it could be argued that economic conditions in 2009 are a lot worse than they were in 2003, the last time the average was at this level.


We have also compared the ten-year gilt yield with the FTSE All-Share dividend yield, as a measure of relative returns from the two asset classes. Taking the difference back to 2000 suggests that equities are not especially expensive relative to gilts, see chart c. However, neither are they as cheap as they were in the six month period following the collapse of Lehman Brothers last year. Typically, in the period since 2000, gilt yields have exceeded dividend yields. Although both yields have dropped back since the recession, the fall has been greater in equities than gilts, hence the reduction in the gap and the brief reversal between September last year to about April 2009. Indeed, it could be argued that it is gilts that are expensive relative to equities, given how much yields have fallen and so their prices have risen. It could be that some of this fall in gilt yields reflects official purchases through the Bank of England’s Asset Purchase Facility (APF).


Taking this point about gilts further, what appears to account for the fall in yields? Decomposing the fall

between the ‘real yield’ and inflation expectations in the financial markets suggests that although the latter hasrisen the former has fallen. Chart d shows this starkly. Inflation expectations may have risen because QE is causing inflation concerns to rise. Record gilt issuance amid signs that economic recovery is starting to gain traction in the UK and wider world may also be pushing up inflation concerns. Further the rise in actual inflation under the influence of higher oil prices in recent months could also be a factor. So why have real yields fallen? That, too, could be because of gilt purchases, which have pushed down yields as demand has been strong. Also, it could be that the real yield is low because short term official interest rates are so low or that economic recovery is not yet assured. But our Risk Appetite Index (RAI) supports this fall in real yields, with a rise in investor willingness to purchase riskier assets, something that the cut to record low short-term official interest rates was meant to induce.


Finally, using a rolling average 5-year PE ratio juxtaposed against the current PE ratio, strengthens

the view that UK equities are fairly priced. Our conclusion therefore is that although shares have revived strongly since March, we should not yet be unduly concerned. Action to improve economic conditions appears to be having their intended effect and conditions for recovery are increasingly in place. Share prices seem to be reacting to recovery as much as to increased liquidity. We are not yet in bubble territory, something we would define as share prices being at least 1 to 2 standard deviations above their long-run average. This may mean that as a Committee, the MPC may continue to vote for further QE, if economic growth early next year starts to disappoint their expectations.

Trevor Williams, Chief Economist, Corporate


Weekly economic data preview –

23 November 2009


A busy week, but little top-tier data, as markets wind down for US Thanksgiving


This week is relatively light of top-tier data, with the calendar instead dominated by US government supply and the upcoming Thanksgiving break. The US Treasury is scheduled to auction $118bn of Treasury notes as it continues to grapple with the financing requirement of a massive Federal deficit. The week sees the release of numerous confidence and activity indicators, including the second estimates of Q3 GDP in the UK and US. Given recent data, we expect US GDP to be revised down substantially. By contrast, a modest upward revision to Q3 GDP is expected in the UK. Amongst other developments, the Fed is due to release the minutes of its November FOMC policy meeting, while in the UK, various MPC members, including Mervyn King, will testify before the Treasury Select Committee (TSC) on the latest Inflation Report. In the Euro area, the calendar is dominated by confidence data, including the latest PMI, European Commission and German IFO surveys.


􀂄 After the recently published upward revision to September retail sales (from flat to +0.4% on the month), we expect the second estimate of UK Q3 GDP to be revised up marginally, from a preliminary reported drop of 0.4%q/q to -0.3%q/q.There is a risk of a stronger upward revision either in this GDP release, or those that follow, as the fall in output reported by the ONS was slightly at odds with the improvements registered in third quarter PMI surveys. This week’s report will contain the first estimates of the expenditure breakdown of Q3 growth. We expect a stronger contribution from inventories and a rise in government spending to have been overshadowed by a continued fall in both consumer spending and business investment. The market will have sight of the business investment data just prior to the gdp release. Given the desire of corporates to repair balance sheets and the ongoing weakness in demand, we expect business investment to have declined a further 6% on the quarter in Q3, taking the annual decline to 24%. The MPC’s assessment of the outlook for UK growth and inflation will come under heavy scrutiny when MPC members King, Tucker, Fisher, Sentance and Posen appear before the TSC on Tuesday. They are likely to be closely questioned on the MPC’s relatively optimistic GDP forecasts outlined in the latest Inflation Report, the differences of opinion that appear to be emerging on the Committee, and their views on the need for further policy stimulus. Also due this week are the CBI’s latest distributive trades survey and the Nationwide house price release.


􀂄 In the US, tradiing conditions are likely to be thin, as market participants wind down for Thanksgiving on Thursday. Thin trading conditions will do little to assist the Treasury as it seeks to sell $118bn of Treasury notes, split between 2-yr, 5-yr and 7-yr maturities. Its fairly busy on the data front, with GDP, consumer confidence, home sales, orders and house price data all due. We expect Q3 gdp to be revised down from an annualised 3.5% to 2.8%, predominantly due to weaker inventories ana a wider trade deficit. The other more timely reports, however, are likely to be mostly stronger, consistent with continued GDP growth in the fourth quarter.


􀂄 Confidence surveys will take centre stage in the Euro area this week. Chief amongst these are the latest PMI and German IFO business climate reports. We expect both the manufacturing and services sector PMIs for the Euro area to have posted further small gains above the key 50 level. Similarly, the German IFO business climate survey is forecast to have risen modestly, building on the recovery that started in March. While the confidence data are likely to point to a further expansion in Euro area GDP in the fourth quarter, the strength of the euro continues to cloud the outlook for 2010. Much will also depend on how quickly credit creation is restored. In this regard, the coming week’s Euro area money supply figures are unlikely to be encouraging.

Adam Chester, Senior UK Macroeconomist


Editorial comments to:

Trevor Williams

Chief Economist

Lloyds TSB Corporate Markets

Economic Research

10 Gresham Street

London, EC2V 7AE

Tel: +44 (0)20 7158 1748


Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


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