Equity markets, which plunged in the aftermath of the terrible events of 11 September, have more than made up the lost territory in the past few weeks. On the surface, this suggests that nothing material happened on the day of the attacks. Obviously, this is wrong. The world has changed and it is hard to imagine it has changed for the better.
The US economy, already ailing ahead of the events, received an unwelcome shock. Political instability in the Middle East has arguably worsened. Risk of a large-scale war has increased. More military outlays will burden government finances for years to come, the famous peace dividend quickly becoming a fading memory of a merrier past. Personal freedom is bound to be curtailed as states will be looking to tighten their grip on security, hoping thus to fend off the risks of more terrorist attacks. Goods will not be able to pass borders as easily as in the past, resulting in delays in shipments and thus increased costs to the economic system.
Have stock exchanges therefore become too optimistic and is a renewed fall inevitable? We think not.
To understand this view, we need to reconsider what drove equity markets in the run up to the 11 September events. At that time markets were driven down by dismal earnings reports as well as by fear for a US recession and the onslaught it might cause on future earnings. It is correct that the attacks have made a US recession unavoidable and that the downturn will be deeper than most imagined only two months ago. This of course explains why markets plunged in the first place. However, the policy response that followed (from the 100 basis point rate cut by the Federal Reserve to the massive fiscal stimuli envisaged by the Bush administration) has increased the chances for a significant recovery. Markets have therefore, to our mind correctly, embraced a V-shaped economic recovery.
The upshot of this is that earnings prospects – although probably a lot darker for the next quarter – have significantly improved for next year. Markets, functioning essentially like a discounting mechanism of future earnings streams, have rightfully taken this improvement into account. Moreover, markets had already corrected quite significantly ahead of September. At the end of August, the MSCI World was down 25.11% in US dollar terms as against August 2000. One has to go back to 1974 to find a 12-month period that was as bad as this one. Clearly a lot of bad news was already in the prices and markets no longer looked overvalued. Europe and Japan even looked downright cheap as against bonds.
Given this backdrop, it already looks less inappropriate that equity markets marched higher after the initial panic reaction. What’s more, they just might continue to rise. Indeed, markets are not only reasonably valued, they also should benefit from ample liquidity. Central banks worldwide are in an easing mode. Moreover, investors have parked a lot of cash in money market funds. In the US, money market funds’ assets represent 20.9% of the market capitalisation of the Wilshire 5000 Index, the highest it has been since April 1997.
That is not to say, however, that the march higher from here onwards is without risks. For even if the V-shaped recovery is now likely, a prolonged recession still cannot be excluded altogether. After the spending binge of the 1990s, consumers – in the face of mounting job losses – might push up their savings rate further and longer than one ordinarily might expect. In this case the current monetary and fiscal stimulus might just fall short of what is needed. In view of this recession risk, it is appropriate to only moderately overweight equities in the balanced portfolios. It also appears appropriate to overweight Europe in the equity part of the portfolios as valuation is attractive and economic risk in Europe appears to be somewhat less than in other regions. Even if the US economy should grow more forcefully in 2002, US equities look less attractive, predominantly because their valuations leave less room for disappointment.
The Japanese equity market on the other hand looks very much like a turn-around candidate and could therefore be a very attractive investment over the next decade. However, it has already held this promise for the past five years. Sadly, up to now even the Koizumi government has not yet taken enough decisive action to allow the Nikkei to realise its full potential. Until the government gets its act together, we continue to underweight Japanese equities.
Jan Deroost is head of asset allocation at Fortis Investment Managment in Brussels