Don't expect too much from equities
Interest rates down, equities up. Probably. 2001 should be OK for equities but don’t expect too much. We expect a total return from equities of 7–10% in 2001, better than cash and bonds but not leaving much room for error when committing new money.
Why aren’t we more bullish? Well, let’s look at corporate earnings first. The US, UK and European equity markets are trading at around 20 times earnings on our house forecast of profit growth of around 7%. Consensus earnings estimates are much higher than our house view and a sharper economic slowdown than we expect could make even our own conservative forecast look ambitious. So for corporate profits the risks are on the downside with particular risks in the first half.
Government bonds are trading above our estimate of fair value. Yields have little scope to fall further without a recession and a further fall in inflation – which wouldn’t be great for equities. In any case shouldn’t we be focusing more on interest rates for corporate borrowers rather than interest rates for government lenders? After all, it was the rise in swap spreads that started the rot in technology stocks last year. For equities to really motor, the market needs to sort out the issuance problem in the telecoms sector. Both the debt and equity markets are suffering heavy indigestion in telecoms. Recovery here requires corporate bond spreads to narrow and risk appetite to rise again.
We believe that one of the keys to markets this year is how spreads on corporate debt react to cuts in rates. If spreads don’t come in, equities are not going very far in a hurry. We will watch this closely in the New Year.
Why aren’t we more bearish? Corporate earnings and bond valuations argue for some caution and – yes – recession in the US can’t be fully ruled out. But as recently as July last year investors were still fretting about ‘overheating’ – and you can’t have a slowdown without some pain! The US economy would have to hit a real brick wall to get much below annualised GDP growth of 2%. The Fed has plenty of scope to cut rules with very little sign of inflation. Inflation is key to valuations – PEs of 20 times are eminently sustainable as long as inflation remains under control (that is 1.5–3.0%). Moreover investors have cash – and with deposit rates falling, equities are the natural home for this. Finally, equity markets have not done a lot for almost two years now. The last time corporate earnings stopped growing in 1990–92, markets went sideways not down. Markets have usefully derated over the past 18 months. Yes, they could derate a bit more; but the outlook for interest rates, a benign inflation background and investors’ liquidity all provide considerable underpinning to markets.
On the currency front, the dollar needs watching closely as it could well weaken further, especially against the euro. This isn’t the end of the world. It’s a fairly normal reaction to a change in differential growth rates between two large trading blocks. The other big currency, the yen, remains vulnerable with the Japanese economy again teetering on the edge of deflation. Further yen weakness should help the dollar at some point.
So what does this mean for our asset allocation? We prefer equities to bonds and cash; and we prefer the euro to the dollar and yen. We believe that it will be a reasonable year for equities – but we will need to be careful in the time of commitment of new money. Within equity markets, we believe that returns will be less polarised and less sector-specific. Ratings will converge further. Companies with good cash flow that deliver expected earnings growth will be well rewarded. We remain cautious on Japanese equities. We are underweight bonds and will increasingly underweight cash in favour of equities. We will remain overweight property. Happy New Year!
Michael Taylor is investment director, institutional funds, at Scudder Threadneedle in London