A backward look ahead

Those who believe stock markets reflect the state of the economy are having to think again. Although share prices have enjoyed a healthy recovery over the past 18 months, western economies remain firmly on the sick list.

In September and last month, many stock markets appeared to have completely uncoupled from their home economies altogether. As Wall Street celebrated its best September in 71 years, US house prices and unemployment figures remained disappointingly flat.

And while the FTSE 100 rose an extravagant 6 per cent, the UK braced itself for public sector cutbacks and years of austerity. Share prices also rose strongly in riot-torn France and deflationary Japan.

These are the best of times, if you're an investor, and the worst of times, if you live and work in the real economy. So what's going on? Is the recent stock market rebound a sucker's rally, or does it signal better days ahead?

The first thing to remember is that stock markets look forward, while economic data looks backward. Markets aren't a vote on the economy today, but where investors expect it to be in the next 12 to 18 months.

"The stock market is a leading indicator," says Bob Gorman, the chief portfolio strategist for the Canadian arm of global stockbrokers TD Waterhouse. "Investors are trying to anticipate what is going to happen next, which means share prices typically move before the economy does."

The good news is that right now, markets are signalling a brighter future. "They are saying that we probably aren't going to get a double-dip recession, or enter a deflationary spiral. Better times lie ahead and that is broadly my view. Economic growth will probably remain below average for this point of the economic cycle, but the good news is at least there will be growth."

But markets aren't an infallible guide to the future. A weak economy isn't necessarily bad news for shares, but a strong economy isn't always good news. If the economy grows too rapidly, central bankers may be forced to raise interest rates to head off the threat of inflation. The higher cost of borrowing hits corporate profitability and consumer spending, and ultimately hurts the stock market.

It is possible to have too much economic growth, Mr Gorman says. "Modest growth of 2 per cent to 3 per cent a year is pretty good for share prices because that is enough to fuel corporate profits without igniting inflation. And looking ahead, I see modest growth."

Booming stock markets haven't completely uncoupled from flailing economies because there is more good news out there than you might think.

After getting the fright of their lives during the credit crunch, major western companies have been slashing costs, shedding workers and boosting their bottom lines. They now boast strong balance sheets, low valuations, dependable earnings streams and diversified revenues.

All this is good for corporate profitability and share prices, but bad for the unemployment figures.

Corporate earnings and liquidity are more important to stock markets than underlying economic growth, says Philip Poole, the global head of macro and investment strategy at HSBC Global Asset Management.

"Corporate earnings growth has been encouraging, with results from many sectors beating estimates. Interest rates are extremely low and the world is saturated with liquidity, which has also been good for stock markets."

Many companies are also sitting on a mountain of cash, which they are too cautious to spend at the moment. It makes their balance sheets look good, but again, the economy is the loser.

It is also important to remember that while many western economies are still licking their wounds, other parts of the world are bright-eyed and bushy-tailed.

Australia has just posted its best unemployment figures since 1988, cutting the jobless rate to just 5.1 per cent. In Germany, the unemployment rate has tumbled to 7.5 per cent, its lowest rate in nearly 20 years. In Brazil, unemployment is down to 6.7 per cent, the lowest since the government began publishing data in March 2002.

Emerging market giants Brazil, Russia, India and China have increasingly uncoupled from the debt-soaked West.

China is growing at a rate of 9.6 per cent a year. India and Brazil are growing at 8.8 per cent a year, and Russia at 5.2 per cent. No double-dip worries for them. Ironically, this doesn't necessarily spell good news for markets. China's Shanghai Composite grew just 0.6 per cent in September.

Western stock markets are reaping the benefit, says Dan Dowding, the chief executive (Middle East and Asia) at IFAs Killik & Co in Dubai. "They have uncoupled from their own economies and are re-coupling to emerging markets instead. The FTSE 100 is a great example. It is loaded with mining stocks such as Anglo American, BHP Billiton, Lonmin, Rio Tinto, Vedanta and Xstrata, who generate between 50 per cent and 100 per cent of revenues from emerging markets, primarily China. The FTSE 100 was once a barometer of the health of the UK economy, but this is no longer the case."

It is a similar story in the US. "McDonald's and Nike both earn around two-thirds of their income from overseas sales, while Apple, AIG, Boeing and Estée Lauder generate more than half. And growth in their foreign markets has been impressive," Mr Dowding says.

The weak dollar has also helped to fire up US share prices. Foreign investors have been using their greater buying power to load up on US shares at a favourable rate of exchange.

This means stock markets haven't completely lost touch with reality. Instead, they have gone walkabout, in search of better returns from China, India, Brazil and Russia.

With emerging economies expected to contribute nearly two thirds of incremental global GDP growth in the next five years, that trend looks set to continue.

The balance of economic power is shifting from West to East, says Alwyn Owens, an independent financial adviser at Dubai Financial Advice. "Investors should follow this trend by investing more of their money in emerging markets."

It is possible for stock markets to rise despite economic stagnation. If you are thinking about investing in the stock market, don't be frightened away by bad economic news from the West. That is no longer enough to send share prices south. Instead, prices are heading East.