Battered and bruised after almost three years of collapsing markets, equity investors have just experienced the largest quarterly decline in US, UK and European shares since 1987. Japanese stocks have also reached a new 19-year low. Consequently, bond yields have been falling sharply as investors have sought shelter. So, why have we moved overweight in equities and underweight in bonds? Quite simply, we believe that the same drivers that pulled markets lower in 2002 will begin to push share prices in the opposite direction again. These key drivers are the US economy; geopolitics; corporate profits; and valuation.
Our models indicate that bond and equity markets are pricing in a US recession in 2003 and consider deflation to be a serious risk. We are unconvinced by the markets’ view and find it difficult to see what will trigger a double dip recession while consumer spending holds up. Consumption accounts for 70% of US GDP and is underpinned by a firm housing market. Although it is a risk, we believe the consumer will not crack, and the US economy will enter a phase of moderate growth. In addition, the Federal Reserve has made it clear that it would act quickly if deflationary signs emerge.
The importance of the US economy cannot be overstated. Even a moderate upturn will suck in imports from America’s trading partners and boost the global economy. Asia and Japan are highly leveraged to US activity while Europe is also dependent on the strength of the revival. In Germany’s case, it could mean the difference between recession and recovery.
Germany’s prospects do not, however, rely fully on the US. Schroder’s re-election has led markets to discount any chance of meaningful structural reform. We believe this is too gloomy and some restructuring can be expected, at least in the labour market. At the Euro-zone level, the prospect of enlargement is looming. Perhaps the prime benefit, counterintuitively, will be the likely paralysis of the EU’s organisation and decision making. We expect that the admission of new members will force some reform of the EU.
The major geopolitical driver, though, remains Iraq, and the recent increase in oil prices and uncertainty about future energy costs is clearly worrying the US consumer. The market impact of any conflict will depend on its duration, incisiveness and outcomes. Most investors’ preferred scenario is a short, sharp offensive, resulting in regime change. This would be welcomed not least because the ‘war premium’ in the current oil price would dissipate, easing the pressure on the cost bases of the world’s manufacturers. The actual outcome, however, may not be this clinical and military strategists’ opinions are divided.
Although macroeconomic and political issues are driving markets, it remains a fundamental truth of investing that share prices profit driven. In the current environment, this means analysing both the quantity and quality of earnings. Regarding the latter, the Enron and WorldCom scandals raised the profile of corporate governance, not just in America but in all major markets. Remedial action was taken quickly to restore investor confidence and the Sarbanes/Oxley Act has already been signed into law. As corporate rehabilitation progresses, investors will become increasingly willing to trust accounts again.
In terms of the outlook for profits, cost cutting has been widespread, unit labour costs have fallen dramatically and productivity has picked up. The overall result is that we have started to see a steady upturn in profits, notably in the US. There have been some disappointments, particularly in high-tech industries. However, S&P 500 earnings do appear to have bottomed. Elsewhere, Asian and Japanese companies are benefiting from the early stages of an export-led recovery. UK profits did not fall as far as the US, so any improvement should be relatively muted. Meanwhile, trading statements from European companies have been largely cautious, reflecting the uncertain economic environment, but cost cutting is starting to be taken seriously. Overall, we believe that this will be a typical cycle for global profits and this should start to be reflected in share prices as the economic picture become clearer and geopolitical noise subsides.
The fourth driver, valuation, is reflected in our asset allocation. Bond yields have been dragged down sharply by the weight of money leaking from equities and are overvalued on the basis of inflation expectations, so we are underweight in bonds. In contrast, stock markets are relatively undervalued having priced in a great deal of bad news.
Within equities, we favour the US, the UK and the Pacific Basin, followed by selected European markets that look undervalued. UK equities are supported by a good dividend yield and US markets by the potential for a profits upturn. The Pacific Basin is highly geared to the global economic upturn, while we are neutral in Japan.
Andrew Milligan is head of global strategy at Standard Life Investments in Edinburgh