Investors continue to shrug off the real economic uncertainties posed by the Asian crisis. Even talk of the Japanese economy slipping from recession into depression has failed to dull investor sentiment in the West. Indeed, in narrow investment terms, Asia's crisis can be construed as something of a benign event. It has lowered global inflation; bond yields have fallen, and the threatened rise in short-term interest rates has been deferred, perhaps put off indefinitely.
All this has been good news for equity investors. There are residual fears over earnings growth, but not enough to dampen investor exuberance, or more accurately, the increased appetite for risk after the stellar rises of recent years.
Thus, on conventional valuation measures equities look overpriced. Dividend yields are at historic lows. Price-earnings multiples are in territory normally only charted in the depths of recession. Even after making the necessary adjustments for low inflation and low interest rates, equity valuations look very stretched. But of course, markets do not fall merely because they are overvalued. It takes something to trigger a fall. Usually, this comes in the form of a rise in bond yields or interest rates as inflation threatens at the end of an economic cycle. But the Asian crisis has extended the cycle and, given the uncertainties in the world economy and the very low rates of inflation currently, it is difficult to see how monetary authorities can risk a more aggressive stance on interest rates.
In the absence of an interest rate trigger, one looks to potential negative earnings surprises to upset the market. The obvious risk remains the threat of Asian contagion but the focus is now on Japan rather the smaller markets of the Pacific Rim. Asset price deflation has wrought havoc on the Japanese consumer. Ineffectual government has greatly compounded the problem. Short-term economic needs have to take precedence over the long-term goal of fiscal consolidation. It has just taken the government a long time to realise this and while it procrastinates over policy, the yen remains vulnerable. We thus remain cautious.
We are also limiting our exposure to the Pacific Rim. The immediate debt crisis may be over and IMF-sponsored policies should help restore these economies to long-term health. But recovery will not be painless and earnings are likely to remain under pressure for some time.
After the rise this year, US equities once more look overvalued. High real cash yields, a symptom of falling inflation rather than higher nominal rates, together with a strong US dollar suggest that earnings will disappoint this year. Given the demanding levels of earnings multiples in the US, equities are likely to underperform this year. Should the market suffer a serious setback, there is considerable potential for a negative wealth shock to cause a severe contraction in the economy.
Within Europe, we continue to have a strong preference for the continent over the UK. Despite some possible downside risk to Germany as a result of slowing Asian growth, the economic recovery should broaden out. Backed by a strong restructuring story, and past currency weakness, the earnings outlook looks secure. Monetary policy is likely to remain accommodative and the peripheral countries are getting an enormous valuation boost from bond and interest rate convergence ahead of EMU.
Even after allowing for possible further gains in sterling, we feel that the UK will not be able to match the returns on the continent. The conflicting forces of recession and inflation continue to pull in opposite directions. The soaring pound greatly complicates matters. UK manufacturing is technically in recession while service output remains robust. Underlying inflation, though not as impressively low as in the rest of Europe, looks non-threatening but some components of the index, such as non-shop services, are accelerating and wage inflation is a cause for concern. Gilts have rallied but would be vulnerable if inflationdisappoints. Given the steeply inverted yield curve, we prefer cash over bonds.
Noel Mills is with Barclays Global Investors in London