“War, war and war,” said Emperor Franz Joseph in June 1914, after receiving the news about the assassination of his son, Archduke Franz Ferdinand, by a serbian separatist. Serbia received an ultimatum, which it did not fulfill and therefore the First World War began a month later. Iraq received its own ultimatum as well. At the time this article was written, there are still many possible political scenarios about how the conflict should end.
All we know is that the US and its alliance are running out of time and they have to take a final decision within the next few weeks. This decision – even in the case of a war – should result in a kind of ‘liberation effect’ for the stock markets, at least for short-term, because there is nothing investors hate more than uncertainty and insecurity. But those who are counting on the world economy and the stock market to take off once the Iraq-conflict is out of the way may be in for a rude awakening. There is no question that the longer there is turmoil in the Middle East, the longer world economies will be operating in uncertainty. Market participants will hold back, taking a ‘wait and see’ approach in their investing strategies.
In fact, the Iraq-conflict is a huge short-term behavioural issue and serving currently as a perfect and welcomed reason for all market participants to hide the real problems. Further, too many investors want to believe that the current war scenario will have a similar effect on the stock market as the 1990-1991 Gulf War.
But, even after Iraq – in the long run – fundamentals determine real value and they are still in question. The US economy is still struggling with considerable overcapacity. Whereas capacity in the manufacturing sector grew by 2.5% annually during the 1970s and 1980s, it increased by 4% annually in the 1990s. Despite the latest recession, capacity remains 18% above the trend and regardless of the economic recovery of the past months, capacity utilisation is only at 75.6%. This implies that the problem is of a structural nature, not only a cyclical one and a quick rebound in investment activity is unlikely.
The situation in the US labour market also remains tense and the number of job openings is at the lowest level in more than 30 years. This increases the risk that fear of losing one’s job will have a negative impact on the consumer spending of private households. Further, the growth in private consumption is built on new debt pushing the consumer and outstanding mortgages credits of the private households to a record but certainly not a sustainable level. At the same time, the higher real estate prices enable home owners to increase their mortgage loans when re-financing. This record-low mortgage rates environment, the flight from equity investments and the demographically fuelled growth in demand for housing have caused a strong rise in real estate prices.
Extreme prices such as those paid for Japanese city locations 10 years ago have not yet been reached. In terms of the national averages, however, the US exhibits excesses similar to those in Japan. Further, even the savings rate of the US private sector as a percentage of GDP has been rising for two years. It is, at a current level of 1%, still far from the normal recession high of around 5%. For this reason, the debt servicing and debt repayment of the customers will reduce future growth as soon as interest rates start rising. The key difference to Europe and Japan is that the US Federal Reserve is doing everything it can to spur debt and maintain the property price bubble.
On the corporate side, contrary to general belief, US corporates are still piling up debt. Companies have transformed their balance sheets and cost structure, moving away from financing leverage toward operating leverage. As a result, over the last few years all sectors’ (excluding consumer staples) earnings volatility has increased. The necessary goodwill write-off and the serious pension underfunding will be additional drags on future earnings.
Not only are today’s earnings overstated, but future earnings power will be lower as well. But once again, the Fed switched since August 2002 to a more aggressive monetary policy and is signaling, if necessary, it is prepared to accept corporate bonds as security or even to intervene directly in the equity market.
Japanese firms are trading at around 1.2 times their book value on average, while nearly two thirds of the listed companies are trading below book value. The price correction is advanced, and the current prices certainly do not take into account the potential for improvement in the microeconomic fundamentals of Japanese companies, which is bound to materialise in the long run. IT and telecom have had good short-term earnings momentum, but in our view they are by far the most expensive sectors. Defensives like staples and health care are relatively cheap now. Utilities are on the verge of becoming over-priced. We recommend to underweight insurance especially in Europe, where the balance sheets of nearly all major insurers are very weak, causing the risk of dividend cuts, divestments of non-core assets and capital increases. We favour regional banks and mortgage finance companies as the mortgage sector continues to be very strong, driven by record-low interest rates. The yield curve is still very steep and deposit growth is strong which could delay the expected narrowing of net interest margins.
So, we see an approaching end to the bear market and the start of a volatile sideways movement with high volatility. For the moment, we are still under-weighted in equities and over-weighted in defensive sectors. We have set the duration of global bonds benchmark-neutral. Alternative investments, such as gold, pan-European real estates or hedge funds, based on their low correlation to the traditional asset classes could be further interesting components of a broadly diversified portfolio.
Ferdinand Bardoly-Küzmös is strategist and portfolio manager with Julius Baer Asset Management in Zurich