On the day after the EU referendum the FTSE 250 index of domestically-focused mid-sized companies crashed 7pc. Investors’ panicky knee-jerk reaction reflected an intuitively obvious belief that the decision to leave the EU would hit home-grown businesses hardest of all.
When markets re-opened after a weekend’s shocked reflection on the immensity of the decision that had just been taken, the mid-cap benchmark fell another 7pc. In just two trading days, the index had crashed by 14pc.
In the market’s crosshairs were the sectors most exposed to a DIY recession – housebuilders, retailers, financial stocks. This week, just a month after the biggest political and economic shock in decades, the index recovered to its pre-Brexit level. It is as if the Leave vote never happened.
In one sense, the market’s sang froid chimes with the latest data. The most recent employment data showed more people working in Britain than ever before. Wages continue to grow faster than prices. The level of economic activity in the second quarter was faster than in the first three months of the year and better than expected.
Unfortunately, these numbers relate to a world that no longer exists. The 14th consecutive quarter of economic growth looks like being the last for some time. Replace the backward-looking statistics with forward-looking surveys and a very different picture emerges. Post-Brexit, businesses are cautious about investing and hiring. A recession in the second half of 2016 looks sure. At the very least we face two and a half years of uncertainty.
So, if markets are meant to anticipate the future, why are they riding so high? A couple of reasons: one domestic, one global. First, the outlook at home may not be as bad as the headlines and the conventional wisdom suggest. The market may be correctly anticipating a brighter future for the UK than it was sensible to expect on June 24.
There are a few reasons to be more cheerful on the UK outlook than the consensus. The political picture is more stable than it looked at the end of June. The almost unseemly haste with which the Conservatives crowned their new leader and her astute appointment of a “reconciliation” Cabinet paves the way for the Government to support the Bank of England in a co-ordinated fiscal and monetary easing programme.
The fall in the pound has also come to the rescue as usual. A nascent rise in inflation as sterling weakens has the potential to boost economic activity by raising the velocity of money around the system and improving the outlook for government finances. The slide in sterling also offers the prospect of more inward investment and inbound takeover activity. A mergers and acquisitions boom could transpire in the months ahead.
But soaring share prices are not just a UK phenomenon. New record highs for the S&P 500 cannot be explained by a reduction in Brexit fears. So the second explanation for today’s rising share prices is that something significant is going on in global equity markets, which in turn is dragging UK shares higher.
What seems to be unfolding – and I whisper these words because they are among the most dangerous in investment – is a new valuation paradigm. Equity investors are following their counterparts in the bond world in starting to think that maybe it really is different this time.
The collapse in bond yields around the world to zero and beyond in many cases represents an epochal upward revaluation of fixed income investments. To understand the scale of this, you need only look at a 50-year Swiss government bond that now offers a negative yield. Investors are prepared to tie their money up for half a century for no return at all.
But that mutation of the “lower for longer” interest rate outlook into a “lower forever” one is now being picked up by equity analysts. If interest rates stay on the floor, they are starting to argue, the average cost of capital for the average business in their spreadsheets is way too high. If capital is assumed to be permanently cheaper, the value in today’s money of future cash flows must rise. And so, therefore, must share prices.
You can probably see why I’m nervous. Investors tend to talk about new valuation paradigms at five minutes to midnight on the stock market clock. Remember all the guff during the dotcom bubble about eyeballs mattering more than earnings? But remember, too, that Alan Greenspan was talking about “irrational exuberance” in 1996, four years before the market peaked. Central banks’ monetary incontinence may be fuelling another asset price bubble but who wants to be the Jeremiah that got out four years too early?
Tom Stevenson is an investment director at Fidelity Worldwide Investment. The views expressed are his own. He tweets at @tomstevenson63.