Earnings the main driver
The global economy is heading towards recovery. Virtually all leading indicators have now moved above the levels recorded on September 11. However, as we never did concur with the excessively gloomy forecasts which were presented by some institutes at the end of last year, we did point out on more than one occasion that it would be wrong to expect miracles from this recovery.
Rate hikes, which will be necessary in the US earlier than expected, might not only put the brakes on capital spending by industry, but also on the spending habits of consumers. As for Europe, the likelihood of progress being made in breaking up encrusted structures over the coming months is not too great in view of upcoming elections in key countries. Nevertheless, it is safe to assume that economic growth in 2002 will come to nearly 2% in the Eurozone, while the US can expect growth even above that figure.
The most important message for equity markets is as follows: the support from monetary sources is coming to an end, meaning that earnings performance will now become the main force driving share prices. On the one hand, equities suffer from rising yields, on the other hand, they should be supported by rising profits over the quarters to come. This is reflected by our STOXX-model which meanwhile shows a neutral position only, although profit expectations have gone up significantly since last year. However, increased 10-year yields have erased the accommodating monetary environment which existed in the last quarter of 2001.
This is reflected in the performance of the markets in the first quarter 2002. Fixed-income markets were suffering from the fact that expansionary monetary policy was coming to an end, while at the same time equity markets were unable to benefit from the economy’s attempts at recovery. Cash was trumps in the first three months of 2002 again!
The economic recovery means that the bond market will continue to provide no support to equities. Equity markets are thus left to their own devices and will have to place their hopes on an uptrend in earnings.
Earnings estimates for 2002 and 2003 – provided that they are accurate – could well provide a certain justification for a further rise in share prices. As far as the Euro-zone is concerned, analysts on the whole agreed on an earnings increase of a slightly more than 20% during the first few months of the new year. Even though 2003 figures are still fraught with a high degree of uncertainty, a further rise in earnings of this magnitude should be possible provided that the economy continues to rebound.
Similar figures are projected for the US. The problem there is, however, that the recession, which is harmless in terms of the decline in GDP, has not been sufficient to correct the high valuations on equity markets. The stock market is thus entering the economic upswing with exceptionally high valuations, which could easily limit the upside potential of US share prices.
The situation in the Euro-zone looks somewhat better. Here, valuations are substantially lower. The publication Bank Credit Analyst says that the discount on European equities vis-à-vis US stocks (measured in terms of the price/earnings ratio) is the highest in more than 30 years.
Our valuation model, too, shows that the valuation of European shares is relatively neutral at their current levels. Owing to the sharp rise in yields at the long end, however, the undervalued situation that was emerging at the end of the year has now been corrected. Taking bond yields into account, shares are no longer cheap in Europe either. In view of the upbeat prospects for earnings we are confident, however, that money can still be earned with European shares in the remaining months of 2002.
Our macroeconomic analyses results in a slightly overweight equity /underweight bond allocation. Compared to a 50%/50% benchmark our investment position has been 55% equities and 45% bonds since September 2001. Especially in Europe we expect another upward-leg for equities in the months to come before we might reduce our equity exposure.
The greatest strain weighing on this forecast is currently the political uncertainty in the Middle East in conjunction with, of course, the well-known fact that European shares are rarely able to move out of step with the US market.
Josef Kaesmeier is managing director of Merck Finck Invest KAG in Munich