The major valuation anomalies of the past few years – equities overpriced relative to bonds, TMT (technology-media-telecommunications) stocks overpriced relative to other stocks, and large-capitalisation stocks overpriced relative to small-capitalisation stocks – have been largely eliminated. Most equity and bond markets are now trading close to fair value, as are most sectors within equity markets. At times like these, a cautious investment strategy is normally wise. The next major move in financial markets is likely to be determined by economic developments, so getting the global economic cycle right is crucial.
This has also been true for the past six months. In January, after the US Federal Reserve first cut interest rates, financial markets moved to discount a sharp, V-shaped recovery in the US and global economies; equities rose and bonds fell. In February, a degree of caution set in as bad news accumulated, and markets priced in a more prolonged (or U-shape) downturn. Then in March, when fears of a global recession arose, equity prices fell sharply and bond yields reached new cycle lows, marking the bottom (so far) of investor sentiment on the US and global economies. There followed a period of improving confidence as the Fed aggressively lowered interest rates and the US administration and Congress agreed on a generous package of tax cuts. In April, financial markets were back to discounting a U-shaped recovery, and by May, a V-shaped recovery was in favour once again. Between March and May, equities and bond yields rose.
More recently, sentiment has taken another turn for the worse. In the face of deteriorating economic news from Japan and Europe and no real sign of an early recovery in the US, financial markets have again moved to discount an extended period of weak growth (or a U-shaped downturn).
Our view is that such swings in sentiment are likely to persist throughout much of the second half of the year. A U-shaped global slowdown has been our forecast for about a year. If we are right, the markets are likely to continue to swing between optimism (after stronger economic news or further interest rate cuts) and pessimism (after poor economic or corporate news).
Why do we favour the U-shaped scenario? First, we expect a prolonged period of falling investment spending in the US. Second, we feel that the slowdown that started in the US is still spreading to the rest of the world, and especially to Japan and Europe.
The late 1990s were an exceptional period for the US economy: strong output growth, a surge in productivity, rapidly rising profit growth, and low inflation. This served to boost business confidence and led to a period of brisk investment growth. In the five years from 1996 –2000, business expenditure on plant and equipment increased at an annual rate of 13%, largely as the result of a boom in spending on IT goods. Such a surge, inevitably, led to a degree of over-investment in some areas of the economy. Now that profits and capacity use are falling, an extended period of weak investment is probable.
This will be a drag on the US and global economic recoveries. Another will be the weakness in the manufacturing sectors of Japan and Europe during the second half. Already there are signs that both are heading into recession (in fact, Japanese output fell by no less than 7% in the first four months of the year), and lead indicators do not suggest that any recovery is imminent.
The outlook for 2002 is brighter. By then, the effects of this year’s monetary policy easing should be beginning to take effect. The global economy should be improving, and equities should outperform bonds and cash. Cyclical sectors are expected to outperform defensive sectors. However, no one should expect the sorts of gains from equities (20% or more) that have followed previous episodes of large interest rate cuts. Those gains were only possible because equities were initially cheap, both in absolute terms and relative to bonds. This time around, equities are not nearly as cheap, and therefore more modest gains (perhaps in the order of 10%) are likely. Similarly, bond yields may rise a little, but only modestly.
Another reason for caution about the likely scale of equity returns over the next year is that the risks to the U-shaped recovery seem tilted towards the downside. In particular, there is still a risk - though less so than at the start of the year – that US consumers will retrench, causing the economy to slide into recession. The rapid deterioration in the Japanese economy, which looks like it will be in recession for much of 2001, is a new global threat.
If neither of these risks occur, equities should outperform bonds over the next 12 months, but it is likely to be a bumpy ride. Now is not the time for bravery and big positions: until the economic picture becomes clearer, caution is advised and small positions recommended.
Tony Dolphin is director, research and strategy at Henderson Global Investors in London