Something has to give – and the winner is: Equities

How can yields continue to fall (fears of double-dip and deflation) and equities continue to rise? One has to give – and we believe it is equities. Why? Simply because productivity will start to fall as there is an upper limit as to how much further you can push workers. Increasing productivity will require higher salaries, but that would be at the risk of margin erosion and ultimately the profits of companies. The current low level of cost growth will support firms short term, but will lead to no income growth and put pressure on future consumption leading to lower sales. In sum earnings expectations will have to be revised lower leading equity prices lower.
Recently equities have rebounded strongly despite weak US economic data and lower global growth forecasts. This rebound has been supported by attractive valuations and the realization that interest rates are going to stay on hold at low levels for much longer in certain key countries (notably US, Japan and Euro-Zone), than originally expected.
One of the more remarkable developments on the back of the rising equity markets has been a rally in global bond markets. The US 10-year yield has plummeted from 3.99% in early-April to 2.60% currently. This drop in US yield has straddled both a period of the falling equity market, a rising USD, a period of rising equity markets and a falling USD (since around mid-year).
Under normal circumstances yields below a certain threshold are liked by equities as they are associated with a more positive sentiment towards economic growth; therefore, while the cost of capital may be rising, it is still low. At higher yield levels, increasing yields is negative for equities as the rising cost of capital becomes the dominant driver of equity prices. Investors have, however, become worried that the recent developments represents a disconnect and either part has to give . In other words: How can yields continue to fall (fears of double-dip and deflation) and equities continue to rise?
We believe that equities will be the part giving in – but not just yet. There is still room for downgrades in equity prices before equities become expensive given the low cost of capital. But our argument is that despite the outlook for major western economies to fall back in recession you should focus elsewhere in order to understand why equities should head south: The development in productivity.
The Great Recession has provided for an unusually high level of unemployment that is not expected to show signs of normalization for at least next couple of years. In fact, several studies have shown that to reach pre-recession levels would require an additional 17 years at the estimated rate of job growth.
As companies have been laying off workers, they have a great deal of room to squeeze the remaining employees for additional productivity. Add to this the advancements in technology, inventory controls along with supply chain management and the result is the better profit margins and EPS – even on limited revenue growth.
But what happens when there are no more bodies to fire? What happens when revenue continue to stay flat as we expect will be the core scenario for 2011?  Productivity starts to collapse as there is just so much ability to push workers any further. While that occurs, the incentive to bring up levels of productivity is higher wages, at the risk of margins and ultimately the profits of companies. This is what we projected to occur in the 2H of 2010 (towards year end), but appears to have shown up a touch earlier. However, the short term the lack of labor cost growth will support firms remain profitable during a time of weakening productivity, yet at the same time depresses income growth and pressure future consumption which eventually will lead to lesser sales. Either or earnings expectations will have to be revised lower leading equity prices lower.