Equity markets started the month in a fairly uneventful way, despite a slightly disappointing Chinese NBS Purchasing Managers manufacturing report. Expectations had been for an index reading of 51.2, in the end it came in at 50.8. As we always point out with these reports, a figure above 50 indicates an expanding economy, a figure below a contracting one. Japan’s move on Friday appears to have increased speculation amongst analysts that any weakness in China data will only spur the Bank of China into further measures to ensure it meets its own growth expectations.
During periods of volatility such as the one we had last month analysts often are prompted to address in their opinion how close we are to the end of the equity bull cycle. A market cycle as described by Citibank in a recent piece of research has four phases.
The first phase as we come out of a bear market is credit leads the way, driven by banks lowering interest rates and the leverage that built up in the last bull market being paid down, mainly as companies swap debt for equity in the form of rights issues. This move continues to put pressure on equities.
Phase two is when economic indicators stabalise and earnings start to improve. Equity markets tend to rise ahead of the earnings recovery as investors anticipate that recovery. At this point credit and equity markets rise in tandem. The equities that tend to lead the rise are small cap stocks and those most sensitive to an economic recovery. Those sectors are the ones that have probably been bashed the hardest in the down turn.
Phase three (where Citi believe we are now) equities continue to rise, as does optimism and therefore leverage. Risk appetite increases, banks may start to gently apply the breaks, equities continue to rise but credit starts to fall.
Finally phase four, the bear market begins, too much leverage in the system and credit falls as speculators sell assets to return leverage. Optimism turns into fear and an economic downturn leads to falling profits and equity prices. After a period of consolidation we start phase one, and so the circle of life returns.
How do Citi decide the phase, they look at the spread between high yield bonds and government debt. Phase one and two the spread falls, phase three the spread starts to rise and phase four sees a sharp spike in spreads. Why phase three? So far credit spreads have risen modestly in the past weeks but according to Citi not in a way to suggest yet that equities are soon to follow.