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0 dawn or not?

Global financial markets are at a critical juncture. After having partially recovered from the sharp decline in the first quarter of this year, stock markets are showing renewed signs of weakness. Whether the second quarter rebound was a false dawn or only the first leg of a more fundamental and prolonged recovery will be mainly a function of US economic performance over the next several of quarters.
While wary of the risks to the recovery process, we remain confident that the US economy will develop sufficient momentum to drive global equity markets higher in the second half of the year. Global bond markets, in turn, are unlikely to repeat last year’s impressive performance. We are also confident that the euro will turn the corner later this year and will unwind some of the undervaluation vis-à-vis the US dollar.
The precipitous slowdown of the US economy since late 2000 triggered a collapse in investors’ risk appetite. The result was a sharp sell-off in equity markets which spread from the US around the globe. It was not until the beginning of the second quarter when the US Federal Reserve finally managed to convince market participants that its aggressive rate-cutting stance would eventually stabilize the US economy and trigger a recovery later in the year.
We believe that the recently experienced weakness in equity markets merely reflects a temporary back-up in risk aversion following the long string of negative economic and corporate news out of the US. However, bad news at the current stage should not come as a surprise since the US economy is hitting the trough of the current cycle. While we expect first signs of a recovery to emerge later in the third quarter, we acknowledge the existence of a formidable Achilles’ heel in the recovery scenario: the American consumer. With US investment growth and export performance likely to remain anaemic well into 2002, consumption growth will play a key role in the next couple of quarters. We are sceptical that this summer’s US tax rebates will be sufficient to offset the pressure on consumer sentiment from a likely further deterioration of the labour market. We are confident, however, that Alan Greenspan will stabilise consumer sentiment with a further interest rate reduction. A benign inflation outlook will keep the Fed in easing mode for “as long as it takes”.
While the recent downgrades of the Euroland growth outlook took markets by surprise, we believe that the effects on investor sentiment will remain limited for two reasons. First, the second-half US rebound should help to contain the slide in Euroland. Second, we believe that the European Central Bank is gearing up to cut rates by 50 basis points in the third quarter. The Euroland economic trough will lag that of the US by one to two quarters, but will not be as pronounced.
A rebounding US economy will help to limit the economic damage in the rest of the world. This, in turn, will pave the way for a further increase in risk appetite and consequently trigger the next leg in the equity market rally. Among the major stock markets, we prefer the US whose strength will only partially spill over into other equity markets. In Japan we are modestly optimistic that the reform plans of the Koizumi administration will boost the stock market in the medium term. Our scenario also calls for an underweight on global bonds. While we believe that further safe-haven outflows will hurt bonds, we are confident that the damage will be limited. The inflation outlook for the US and Euroland is benign while central banks are likely to hold interest rates low for the foreseeable future. As a result, yield increases will be moderate.
The euro is likely to stage a recovery before year-end. Positive growth surprises in the US relative to the Eurozone have been the main driver of the euro/dollar rate over the past two and a half years. Currently market expectations of US growth for 2001/02 appear slightly stretched, while latest revisions to Euro-zone growth provide some insurance against negative surprises. Growth differentials are therefore likely to surprise in favour of the euro, which should help to unwind some of the fundamental under valuation of the European currency. At the same time, we believe that the question marks behind the ECB’s credibility, which added to pressure on the euro during spring, will soon fade away. The resulting upside for the euro is further accentuated by the likelihood of renewed ECB foreign exchange intervention should the euro retest the lows of last fall. Our overweight on the euro is contrasted by an underweight on the yen. Easier monetary policy in Japan is imminent and will weaken the yen at a time where international resistance against a weaker yen is fading.
Markus Krygier is head of strategy at Credit Agricole Asset Management

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