Dubious about recovery
Although the global economy shows signs of a slight improvement, we are still far from a self-sustaining economic recovery, either in Europe or in the US. A highly expansionary monetary and fiscal policy has led to only meagre growth in the US, while the Euro-zone has been in a phase of low growth.
Consumer demand hardly exists in the euro-countries and remains artificially high in the US. Although the US consumer is still encouraged to spend by extremely low interest rates and tax cuts, the post Iraq war optimism has already faded. Even worse for industry, there are still enormous overcapacities which were created by the excesses of the late 1990s. As Chart 1 shows US industry suffers far more from overcapacities than the European industry.
A further point which encourages caution about future growth is the highly indebted private sector in the US. This will be bad if there is deflation (as the bond market seems to expect) and even worse if the Fed tries to get the economy out of the woods (which the equity market started to play in the second quarter) by creating excess liquidity, leading to higher inflation and rising interest rates later in the cycle.
Unfortunately, Europe will not become the driver if the US stumbles. The European Central Bank was too far behind the curve and the Maastricht criteria impede a more expansionary fiscal policy. Additionally, the euro is nobody’s favourite child. It was out of favour when it was weak. Now it is strong, it is even less popular. As the US uses its currency to reflate their economy, having almost exhausted fiscal and monetary policy, European exports will slow. Until now, these exports have been the main driver for the sluggish Euro-zone growth. Therefore we expect growth to stay below average in the US and Europe this year and next year, with the risk that after a short recovery in 2004 the world economy may dip lower again.
Equity markets, however, seem to prefer a more optimistic scenario. After more than three years of falling share prices equities were overdue for a correction. Meanwhile markets have risen 30% to 40% from their lows and the most-watched US index, the S&P500, has broken its long-term downward trend and remains firmly above the 200-day moving average.
European equities are lagging the US indices once more. However, as these markets have lost even more than the US market they have also recovered substantially. The big advantage for Euro-zone shares is valuation. Whereas US shares stayed far above historical price-earnings ratios throughout the bear market, Euro-zone equities were fair valued on average.
Additionally, we have seen a strong spread tightening in the corporate bond markets, which fits in to the game equities are playing, namely an economic recovery. On the other hand, government bonds have also been extremely bullish over the recent months, which is not compatible with this economic scenario.
If equities are right, the bond bubble could burst and US real estate could become the next problem area. If bond markets are right and deflation becomes the central theme for US and Europe – as it has been for years in Japan – the rally in share prices should soon come to an end and new lows could be seen in 2003 again.
How are we positioned in this ambiguous environment? On a strategic long-term view we expect equities to go sideways for a few more years as has been the case after all extreme valuation excesses. However, this sideward trend will be accompanied by strong ups and downs within. Therefore, tactical asset allocation will again become the most important part of running balanced portfolios.
According to our valuation model (Chart 2) we started to increase our Euro-zone investments slightly too early in October 2002. Meanwhile, we went overweight for the first time in three years for our conservative clients (benchmark: 80% bonds, 20% equities) in March. However, after the recent strong rallies of nearly all equity markets in the world, the next decision point will be when to reduce shares again.
Josef Kaesmeier is managing director of Merck Finck Invest in Munich