A year ago, a combination of factors led to a global recovery. These same factors were present at the end of 2002, albeit to a lesser degree, and should help activity to pick up at the very start of 2003:
o monetary policies and to a lesser extent fiscal policies remain accommodating all over the world;
o final demand is holding up and inventories are very low;
o the improvement in financial conditions indicates an easing of investor mistrust and may signal a decline in industrials risk perception.
The recent ISM rebound was an excellent sign pointing in the direction of an end to the soft spot that began last summer. The Euro-zone should benefit via the revival of world trade, despite its lack of macroeconomic and microeconomic flexibility. Asia should also benefit from a revival.
However, it does not allow us to conclude that the US economy has definitely recovered from its soft spot. The high probability of a US-led attack on Iraq will be a predominant factor of market action this year, directly via the ensuing uncertainty that weighs on investors decision and indirectly via the effects it has on oil prices. Let’s keep in mind that oil price variations remain one of the main factor of the business cycle, and that financial markets hate nothing more than uncertainty. In a way, an early war would probably clear the horizon and allow a much awaited drop in oil prices.
Faced with both the geopolitical risk and the uncertainties about growth, Monetary authorities will take their time before raising their key rates. But once those uncertainties at least partially lifted, say in the second half of the year, the central banks are likely to initiate their series of interest rate rises. Once started, interest rate rises will come at regular intervals. The Bank of England is likely to be the first because of the inflationary risks associated with rising real estate prices. Logically, the decline in the bond market would intervene only at mid-year and be sustained by public finances deterioration. Long term interest rates are likely to rise to around 5% on both sides of the Atlantic.
Although it is not possible to completely rule out a deflation scenario, we believe capital over-accumulation has been absorbed globally. The resilience of final demand, the fall in the cost of capital and the already substantial adjustment of investment all favour a renewed build-up of capital. However, this central scenario is subject to two major risks.
First, the financial shock may have a longer-term impact on expectations and businesses may therefore be very slow to resume expenditure on capital goods. Consequently, potential growth would be revised downwards and the extraordinary advanced gain in purchasing power granted by the fiscal and monetary authorities will have been excessive relative to growth prospects.
Second, even if investment turns out to be sufficiently dynamic to maintain the productivity gains, the Clinton-Greenspan era of restoring public finances to health is over (the recent Bush plan definitively suggests it), which means that government expenditure is replacing corporate investment as the driver of the economy. A sustained increase in public-sector deficits would therefore lead the markets to question the balanced nature of US economic growth and the financing of the US economy. Both these risk scenarios would put a brake on the rise in equity markets. But they would especially weigh on the US dollar.
Today, the two factors that encouraged the bull market in the late nineties, namely unrealistic corporate earnings expectations and a belief that the fall in the risk premium was permanent, seem to have come back to reality. The medium-term earnings growth forecasts are currently around 13% (compared with 19% in August 2000, which was excessive), and the risk premium is back on its high. So if the first quarter of 2003 allows the two main remaining risks – Iraq and the economy – to be at least partially lifted, the equity market should postpone a reasonable rise over the year of around 15%. However, confidence on the part of investors will probably take time to be restored, and the road to the rally is likely to be bumpy. As a result, in our asset allocation, we are over-weighting the equity market only slightly.
Roland Lescure is head of global balanced and global equity funds, and head of strategy and research at CDC-IXIS Asset Management in Paris