WorldCom changes little
Already under pressure, equities in the US have been hit by another corporate scandal. But as telecommunications giant WorldCom revealed a $3.8 gap in its accounts, strategists said the news made little difference to the market’s already poor prospects.
Institutions continue to shift holdings from equities into the relative safety of bonds, and the WorldCom news simply bolsters their reasons for taking this approach, strategists say.
Chris Johns, chief strategist at ABN AMRO in London, says the optimistic view of the WorldCom scandal is that the market is getting used to it. “The WorldCom share price had collapsed anyway, though no one knew the specifics,” he says. Suspicions of irregularities had been factored into the price.
But the news has clearly dented market sentiment, says Khuram Choudhry, equities strategist at Merrill Lynch.
The US market had already been plagued by doubts in the wake of the Enron scandal. Many investors had become wary of relying on earnings figures as published by the companies themselves. They were asking whether the accounts of any more major companies would be shown to be false, and now there is more urgency in those questions, says Johns. “Before, we hoped it was just Enron,” he says.
Choudhry says it was a shock to the market to find out which the next corporate disaster was, but fundamentally, the news has not changed the environment for equities. He sees the lastest scandal as an indication of the bull run in the technology, media and telecoms sector seen two to three years ago. Companies in the industry were under enormous pressure by investors to come up with promising results.
“This is something that happens historically in bull runs,” he says. But it indicates what has gone on in the past rather than predicting what will happen in the future.
Although Johns says it will be very difficult for stock indices to make much progress from here, he points out that at least the market is forming some type of floor. “Overall, market valuations are establishing some sort of fair value. In order for the market to move forward, it has to go back to economic fundamentals,” he says.
On the whole, share price valuations are still seen as high, particularly in the technology sector.
Johns says given market sentiment, it is difficult to see what kind of catalyst will come through. Following the lows plumbed in the wake of September 11 last year, the markets bounced back in October and November. But since then, many in the market have been reassessing the received wisdom that dips should be bought, he says.
Investors are worried that earnings growth will not turn around and that global terrorism will continue, he says.
Choudhry says Merrill Lynch’s strategists are still taking a cautious approach to the US stock market. They favour exposure to some defensive stocks, but are not keen on technology and some consumer sectors, he says. Growth prospects in the highly-valued telecommunications sector could deteriorate further, he says.
Up to now, the US consumer has had a relatively easy time, he says, with the cost of borrowing low and residential property demand high. But recent economic data, including unemployment figures suggest that the consumer may be about to throw the towel in, he says.
Haydn Davies, asset allocation strategist at Barclays Global Investors points out that while US consumers were happy to carry on spending last year, consumer credit growth has begun to wane as households come to terms with rising unemployment and weaker wage growth.
But policymakers at the US Federal Reserve do not appear to be in a hurry to increase the cost of credit. Recently, the central bank merely said that the current low level of interest rates was likely to end sometime in the future. Merrill Lynch’s economists in the US have now changed their forecast on rates, predicting a rise in November – later than the August or September hike they had been forecasting.
Deutsche Bank sees Fed Funds standing at around 2% at the end of the year, up from their current level of 1.75%. Fed Funds futures already largely discount this, says Ifty Islam, fixed income strategist at Deutsche in New York.
There is a minority in the market who expect to see the Fed tightening credit before the end of the year, he says. But if trading activity in the equity market remains as bearish as it has been in recent weeks — and assuming the unemployment rate decline of May was not representative of the underlying trend — then these residual expectations should die away, he says.
The dollar has fallen since the beginning of the year, and is now down about 9.5% on a trade-weighted basis since January. Davies says that after business and consumer confidence dipped in April, the dollar has been further knocked by talk of a double-dip recession.
But Deutsche Bank’s economists do not see a double dip recession happening in the US, and forecast above trend economic growth for the rest of the year. “But the key risks to that are that capex spending comes back on track in the second half of the year to compensate for a diminished contribution from inventory re-building,” says Islam.
But if that fails to appear, the Fed would be concerned about the economy losing momentum, he says.
Markets now need to regain some poise, says Johns. “Even on a half-decent growth scenario… one has to concede that stocks are expensive,” he says. “It’s hard to see anything other than a trading bounce happening – and one that one can’t trust.”