Mind the gap
Global economy bears have been on the defensive since January and in full retreat since the end of February. Now, only a handful of die-hards still fear the US is going to experience a ‘double-dip’ as debt-burdened American consumers stop spending in advance of any substantial pick-up in business investment.
This has been a remarkable turnaround. At the beginning of the year, the market believed that the US economy had shrunk at an annualised 1.1% rate over the fourth quarter of 2001, little better than the 1.3% negative growth rate posted during the third quarter. In fact, it now appears that the US economy actually expanded, rather than contracted over Q4, with growth coming in at a respectable 1.7% annualised rate. It now looks as if the US downturn might prove both uncharacteristically brief and notably mild.
Given that the economic prospects of the US have long been the chief driver of global investment sentiment, this shift in the outlook should have fuelled a bright start to the year for global equities. But it hasn’t. It did prompt a late February rally that extended into early March, but the developed markets have otherwise trended lower, with the broad US market back below its year-end level in mid-April and the Nasdaq hit much harder. Most other major markets around the world have declined in sympathy and only amongst the emerging markets, where US import demand is usually critical, has there been an unambiguous celebration of the improving outlook.
What does this all mean for asset allocation? The power of singular events – the tragedy of September 11 or the Enron meltdown – to drive short-run performance has been abundantly illustrated in recent months. But it’s always important to distinguish the wood from the trees. In our view, at least in investment terms, these issues have been trees, not wood. On a slightly longer-term horizon – a six-month view drives our asset allocation – the fundamentals tend to re-assert themselves. This perspective, which helped us to weather the storms of the second half of 2001 in fairly good order, continues to suggest that an equity overweight is the appropriate strategy going into the second quarter of 2002.
We believe that the improving outlook for the US economy – which is certainly the prime input to our asset allocation model – will prove to be the chief driver of equity performance over the coming months. But it’s important to recognise that the prospect of top-line growth alone isn’t enough to justify an equity advance: investors must also be convinced that stronger activity will translate into higher corporate earnings and that earnings growth is accessible at a reasonable price.
On the first count, we think Enron was an aberration, if also a typical post-bubble bust, and that the significance of its failure should not be exaggerated. As some perceptive UBS Warburg research recently argued, fraud shouldn’t be confused with aggressive accounting and the recent stability of the ratio between operating cashflow and GAAP net income doesn’t suggest a general decline in the quality of reported US earnings.
Valuation, along with a concept we call ‘dynamics’, is central to our London asset allocation model. The valuation side of the model attempts to determine the central tendency of prices based on the historical relationships between key variables. The dynamics element incorporates historical mean reversion rates and analysis of momentum to determine the likely rate of convergence with a long-run fair value level.
Although P/Es in many markets – including the US and UK – still look high by historical standards, equity valuations look far more reasonable once we allow for the current benevolent inflation environment, which we factor in via bond yields. With earnings expectations rising fast as the threat of a prolonged global slowdown recedes, we see a significant valuation gap – the gap between prevailing price and the fair value level – in most of the world’s equity markets.
When we feed in our dynamics process, allowing us to estimate the extent to which the valuation gap will be closed over the next six months, we end with up an implied return for each key equity market. Comparing these returns with the implied returns across the bond markets and the returns available from cash, we find that equities are favoured over bonds and bonds over cash.
Amongst the developed equity markets, the model currently favours continental Europe, where a sizeable valuation gap is further enhanced by positive dynamics. The UK market looks rather more attractively valued than Wall Street, but the US offers superior dynamics, leaving it marginally ahead on balance. Japan looks the least appealing of the major markets. The model also forecasts robust performance from the emerging markets.
Complementing our work on markets, global sector research now plays a prominent part in driving many of our investment processes. Our sector modelling presently favours IT and telecommunication services, where we’ve seen a substantial improvement in expectation data, although trailing data remains weak. Elsewhere, our model prefers industrials, consumer staples and utilities, finding less merit in the healthcare and consumer discretionary sectors.
Turning back to the broad picture, we don’t see Wall Street stocks or the US economy setting the pace this year. However, our analysis suggests that both should achieve a useful advance – providing the necessary, if not sufficient, conditions for more significant gains elsewhere.
Anthony Broccardo is chief investment officer, institutional and overseas, at INVESCO Asset Management in London.