World financial markets are at a critical juncture awaiting the US political response following the terrorist attacks in New York and Washington. The shock comes at a time when tentative signs that the monetary easing witnessed this year were starting to impact the US economy. The key consideration now is whether the adverse effect on consumer confidence will undermine consumer spending, pushing the global economy into recession. Any negative impact on GDP may be magnified by the rise in the oil price, the destruction of a significant part of the US financial sector and the disruption caused to business, given the likely impact on air travel. Globally, this may also prolong the downturn in Europe and Asia. Against this backdrop, we expect the Federal Reserve and central banks in Europe and Asia to cut interest rates further to prevent a sustained slow-down in economic growth.
Comparisons with previous exogenous shocks are difficult. The Iraqi invasion of Kuwait led to a sharp fall in equity markets, consumer confidence and the US dipped into recession in early 1991, but the markets and confidence quickly rebounded. The Kobe earthquake in Japan took an estimated 0.3% off GDP in the first quarter of 1995. However, activity soon recovered as rebuilding subsequently boosted GDP and the Japanese equity market rebounded from its sharp fall. In both these cases there was a one-off shock to activity, which was quickly reversed as either the risk premium fell (Gulf War) or rebuilding began (Kobe). Reconstruction will aid the US in coming months, but it is unlikely that the risk premium will disappear until there is more certainty about the US political reaction. At present we are not changing our policy, we continue to believe that given the extent of falls already witnessed in equity markets this year now is not the time to sell. Any negative knee-jerk reaction by markets on the back of the events in the US will provide a buying opportunity as the policy response by central banks is likely to be quick and aggressive and that this should be sufficient to avert a crisis in world financial markets.
The best is probably behind us in terms of bond returns, and as we are near the end of the interest rate easing cycle, bonds could be in for a period of under-performance. As investors become more confident that a financial crisis will be averted, the ‘safe haven’ status bonds have enjoyed is likely to diminish.
While the cyclical outlook for equities remains positive, the structural bull market now appears to be over and returns going forward are likely to be much lower than they have been during the last 15 years.
In such an environment, the breadth of equity market performance is an important issue to consider. So far this year, the lacklustre performance of aggregate stock indices has continued to mask the underlying relative strength of many stocks.
In the MSCI US Index the median stock has on average underperformed the index during the last five years, it has materially outperformed during the last 12 months – in fact, showing strong absolute price gains. For this reason, we continue to prefer mid-cap stocks where it is easier to find better value.
At a regional level our preferences remain continental Europe and the US. The US market is expected to benefit from being further through the cycle as policy makers have responded quickly to the growth slowdown. The Japanese market rallied initially on the surprise appointment of Koizumi as prime minister, who was seen to be the ‘pro-reform’ candidate. However, signs that the proposed reforms are being delayed, combined with economic data suggesting that Japan is slipping back into recession suggests it is too early to get more positive about Japan. The UK tends to be defensive and performs well when growth is deteriorating and other markets are struggling. From a sector perspective, the high weight in defensives leads us not to favour the UK market.
Recently we have become more optimistic about the prospects of European equities, raising exposure at the expense of the US. At the start of the year, Europe was most investors’ favourite area, with many strategists arguing that the region would be immune from the effects of a slowdown in the US. Should investors become confident that the global economy has troughed then European equities are likely to benefit.
Tom Joy is an analyst at Schroders’ Investment Strategy Unit in London