Indications of over-selling
After a violent correction over the summer months, equity and corporate bond markets remain in a highly difficult and volatile environment, due to the negative impact of deteriorating global economic expectations and sabre-rattling over Iraq. The increasingly emotional behaviour in the markets makes any forecast highly risky, but let us try at least to look rationally at what we know, without being too influenced by prevailing sentiment.
Economic trends justifiably have a strong influence on markets: ex-TMT equity indices behaved favourably during the first part of the year, at a time when economic activity gathered steam. Likewise, the plunge in these indices, starting in June, coincided with a slowing recovery. These turned into fears of a double-dip’, with business climate indices falling in August to levels dangerously close to signalling a recession. Are these recession fears justified? We think not. Focusing on the US, still the sole growth engine for the world economy, consumer demand remains primarily driven by real disposable income, which is rising due to wage growth, tax cuts and a more stable, albeit far from buoyant, labour market. The housing sector remains supported by demographic trends, and prices are far from excessive in historical terms when compared to the level of household revenues. Finally, investment in technology is starting to show signs of life after a very severe fall in 2001 In our central scenario, the US economy should therefore continue to grow into 2003, but persistent structural problems in terms of excessive debt and investment levels will keep growth below trend. This looks more like 1991-1993 than the end of the 1990s! In addition, risks are clearly tilted to the downside: escalating tensions in the Middle East could lead to even higher oil prices, whereas falling equity prices could induce companies to another round of cost-cutting in the autumn, both events being susceptible to derail consumption.
In terms of earnings, recent news has been more encouraging not been so negative. US companies have met or beaten analysts’ expectations during the second quarter and, more importantly, given investors’ present distrust regarding reported earnings, profits at the macroeconomic level have already started to increase (at a 10% year-on-year pace) as early as the first quarter of 2002. This shows that a fundamental trend towards higher profitability has started. Admittedly, consensus forecasts are still too optimistic, with for instance a 25% expected rise for the MSCI Europe index for the next 12 months, but a significant increase in earnings is still quite likely for both 2002 and 2003 in the US and Europe, Asia being able to deliver higher figures.
What about valuation? Our models also give us positive indications on this side. At around 15, the US market PE for 2003 is not far from its long-term average, but interest-rate-related measures show that equities are undervalued to a large extent, with inflation and rates far lower today than in the past, and set to stay so: the Fed has shown its readiness to cut its leading rates if economic conditions require it. The ECB has a margin of easing as well, after a rare acknowledgement from its chief economist of the downside risk to the economy. Government bond yields are admittedly quite low, but in a slow growth context, where deflation is more to fear than inflation. On the basis of a still significantly sloped yield curve, at least in the US, we do not see much risk in keeping an overweight duration in our fixed-income portfolios. The problem with valuation models based on earnings is that the forecasts they use are probably over-optimistic, and one may in this respect believe that in a slow nominal GDP growth world, long-term earnings should increase less rapidly than the 10% figure oft quoted in consensus surveys, without mentioning the risks derived from under-funded pension funds. Bearing this in mind, it may very well be that investors require a persistently high risk premium to buy equities, due to uncertainty regarding economic prospects as well as reliability of company accounts.
In summary, we believe that from a long-term standpoint, equity markets are attractive at today’s levels with technical indicators suggesting they are oversold, though the timing of their recovery is difficult to determine. Persistent high risk (volatility) levels lead us to maintain a neutral to slightly overweight equity stance in our balanced portfolios. The regions we favour are Asia ex-Japan, which is increasingly a domestic-demand rather than an export-led story, and emerging markets where valuations are attractive and which offer good diversification potential. We have no strong conviction in choosing between the US and Europe, and keep a cautious stance on Japan as long as it remains caught in deflation. In terms of stock selection, we believe that risk should be kept under control as well, and would focus on the ‘balance-sheet survivors’, especially in the IT sector which has been heavily beaten down. We also like healthcare, whereas we stay away from deep cyclicals.
Eric Tazé-Bernard is chief investment officer at INVESCO France in Paris