Don’t chase market rally based on cheap cash

IF IT’S too good to be true, it probably is. It’s a timeless warning that I suspect has saved investors from folly when optimism runs ahead of events.

Last week, share prices round the world hit their highest levels since mid-2008. And the UK market, helped by a big boost from mining stocks, enjoyed its sixth consecutive week of gains and joined in. It closed up 58.28 on Friday at 5,770.98, a gain of 0.5 per cent on the week, taking the index up 6.6 per cent since the start of the year.

And there’s no doubt about a better news flow for the economy. Figures last week showed UK industrial output bounced back in February with a 1 per cent gain on the month. This tallied with a strengthening trend in the manufacturing sector tracked by recent survey data such as the Chartered Institute of Purchasing and Supply’s main Purchasing Managers’ Index.

The return to growth in February took the quarterly growth rate to 0.8 per cent; the third successive month in which the quarterly growth rate has been positive.

This follows PMI data showing a return to growth for the first time in two years in the construction sector in March and the 11th consecutive month of growth in the service sector. Overall, the latest short term indicators imply growth continued in the first quarter, despite a sluggish start in January.

And the economy is starting to show traction here in Scotland. Data on the Scottish private sector economy released today signals another overall expansion of activity levels. According to the Bank of Scotland Purchasing Managers’ Index, these rose for the ninth successive month during March.

Arguably the biggest fillip to confidence came last week from the OECD. Its interim economic assessment for the major industrial economies predicted that the UK economy will grow at the second fastest rate of the G7 for the second quarter of this year.

This is all encouraging, if still fragile and tentative in many areas. This prospect of improvement has helped sustain the stock market. But ironically the biggest prop to the recent rally has been official doubts as to how strong this pick-up really is.

Note the statements from central banks here and in the US that interest rates are likely to stay at today’s ultra-low levels for, in US Federal Reserve parlance “an extended period”. And nothing inspires stock market rallies more than cheap money. But how long can the cheap money last? And how might political uncertainties in the UK disrupt this better picture for investment markets?

The biggest threat to markets remains the billowing pile of sovereign debt and the questions it inevitably begs: who is going to fund it, and at what price? Greece has been the immediate focus of attention. But the worries are far from confined to Greece. Last week saw US bond yields climb more than 4 per cent at one point, reflecting market concerns over the sheer volume of debt that the government is seeking to borrow. The US government has a mountain of debt and is continuing to spend heavily. This is chipping away at confidence in the single greatest asset held by global pension funds and the belief that government bond markets are a safe haven for investors in uncertain times.

The more the doubts crowd in, the higher government bond yields will go to compensate investors for the greater perceived risk. And it is these yields that have a huge influence on the cost of money.

Here in the UK, attention is focused on the election and the prospect of a hung parliament. Some argue that this may be no bad thing, requiring parties to work together. And for the moment it seems the stock market is quite relaxed.

But Douglas McWilliams, chief executive of the Centre for Economics and Business Research, reflects in a report this morning on the previous period of a hung parliament in the 1970s, when he was chief economic adviser to the CBI. He recalls that business lobbyists at the time were more effective than those pressing for more spending and regulation.

However, this time around, he’s not so sure. Compared with the 1970s, business pressure groups, he says, have lost influence, while environmental and other single issue lobbyists (who by and large favour increased regulation and government spending) have gained in influence. “So I am not convinced,” he concludes, “that a hung parliament would work as benignly for the economy as in the 1970s.”

I agree with this assessment, and am not at all comforted by the prospect of a hung parliament from an investor standpoint. Thus, for all the favourable headwinds in recent weeks, my advice would be to stay on the sidelines and not to chase this rally.