Recession still at bay
A double dip in the US economy is once again on the agenda in the financial markets. However, we do not see the economy in a new recession. First of all, the American consumer is compensated for falling stock markets by a continued strong property market. Having said that, we also realise that the property market plays a very important role as a stabilising factor. Secondly, we expect a pick-up in corporate investment as increased capacity utilisation and earnings growth are realised. The above scenario is not without risk and could prove very vulnerable. Oil prices and another downturn in equity markets might be the biggest risk factors.
In Europe we have seen a number of disappointments, and there is no hope that Europe will assume the role of growth driver for the world economy. However, we do not expect Europe to fall into recession, which is why we see neither the Fed nor the ECB lowering interest rates again. On the other hand, interest rate hikes are not expected before mid-2003.
Although the dollar has regained ground lately, we see scope for a weaker dollar and a stronger euro on a medium-term outlook. The huge current account deficit will create a strong need for attracting foreign capital on an ongoing basis. With the sudden shift towards waning appetite for equities and foreign direct investment, the US will increasingly face problems with financing their current account deficit. We expect this transition to be gradual, however, and do not see a collapse of the dollar.
Our recommended asset allocation strategy is based on this scenario, but it is clearly our opinion that short-term movements and volatility will play a very important role in designing the optimal allocation – especially in a world where competition among asset class returns will be very tight. Our strategy is based on two views: 1) return potential and 2) market timing.
When evaluating the return potential of equities and bonds it is essential to look at the recent market drivers. We believe that the sharp drop in equity prices this year is justified by the huge uncertainties arising during the year. The risk premium should clearly be higher in this market environment.
However, at the present valuation levels we are confident that equities can deliver a competitive return relative to bonds on a 12-month investment horizon. This is further supported by the fact that we will probably need a double dip in the economy or increasing risk of deflation for nominal bond yields to move substantially lower. As already mentioned this is not our expectation. Finally, financial market sentiment has been bond-yield friendly for some time – but eventually risk assessment will improve. At best, we look for a flat return on international government bond portfolios over the next few months.
Our market timing considerations are based on a strictly quantitative approach. To capture the short-term impact we are utilising proprietary models estimating the probabilities of outperformance of an asset class. These models currently reflect that equities are not yet attractive under the existing market conditions. Any of the following three factors could be triggers for an entry into equities:
1 Lower credit spreads; 2 Stronger macroeconomic momentum; and 3 Lower valuations.
Credit spreads are falling at the moment, albeit from very high levels, and we still see this as a reflection of the high risk aversion among investors. The macroeconomic momentum is currently not picking up, but as we do not believe in a double dip in the US economy, positive surprises could be on the cards. Finally, valuation is low by traditional measures like bond yields to earnings yields, implying that lower levels on volatile days could create strong buying opportunities.
On a long-term outlook we see potential for equities but are also quite cautious about entering the market given the present uncertainties. We recommend a very moderate overweight of equities and cash – getting ready to move into the market when our short-term indicators improve. The increased volatility certainly creates new challenges on tactical asset allocation - but at the same time it also creates new investment opportunities.
Poul Winslöw is head of tactical asset allocation at Nordea Investment Management in Copenhagen