GLOBAL equity markets, having bounced from their “end of the world is nigh” levels reached in March, gained a second wind in July and have since rallied a further 20%.
This followed economic evidence that economies had passed the weakest point of the recession, with the rally being fuelled by the surprising strength of earnings reports for the first half of 2009.
The positive surprise was driven more by cost-cutting than stronger-than-expected sales, which prompted some scepticism. Cutting costs is a normal response to recession, but the concern was that such gains to profitability would not be repeatable and could be reversed if demand remained sluggish and forced companies to pass on the cost cuts by lowering prices.
Happily, the evidence of improving demand has been stacking up in recent months, which has encouraged companies that cut back production too far last winter, in anticipation of further weakness, to restore some of those cuts and, in some cases, rebuild unduly lean stock levels.
The forthcoming corporate reporting season will be a test of whether those sales increases will flow through to a “better quality” profit surprise than one driven by cutbacks alone. With markets at higher levels, the hurdle for beating expectations has been raised, so it seems possible that there will be a wider spread of surprises than three months ago, when there were prizes for all.
This could lead to greater discrimination between well-managed companies with above-average growth prospects and those relying upon a strong cyclical tailwind that might not blow. “Hope” stocks might start to flag, as the “delivery” stocks show their paces. Nonetheless, the turn from recessionary conditions should mean that the balance of results is a positive one.
Although the restoration of growth and consequently reduced pressure on investment and employment levels is a welcome contrast with the fears of six months ago, the political reaction seems decidedly mixed.
The return of mega-profits in the investment banks has created an outcry about the credit bubble being recreated, driven by ludicrous rewards being paid to “greedy bankers”. The facts are more mundane.
Investment banks are returning to boom profits because the financial markets have recovered in advance of the economy, as is normal. Commercial banks are still struggling with bad debts and rebuilding their capital base.
Analysis of both types of banks’ operations shows that they are running more conservative balance sheets than before, with less leverage and tighter loan conditions. While this may not be a recipe for popularity with their customers, it is not reflating the bubble. The point that profitable companies, and their staff, pay taxes, has barely been made, yet the yawning gap in the public finances has opened up largely because of a collapse of tax revenues.
Regulators will want to ensure that the activities of the financial sector are more conservatively regulated than in the past, once the natural discipline of recession passes, but a recovery of company profitability should be celebrated, not damned. You can’t tax a corpse.
