Under old economy stock market lore it used to be sound advice not to ‘fight the Fed’. In the new economy, many have chosen to ignore this year’s mission to restrict the supply of liquidity and raise the cost of capital. Somehow, new economy stocks were viewed as being untouched by economic reality. We do not believe this and have positioned our portfolios accordingly.
Although we are cautious on equities, we are not bearish. Our caution comes from looking at the bigger picture. We acknowledge that there may be evidence that the US economy is slowing down but we believe the Federal Reserve Bank will continue to watch for consumer spending and inflation in goods and services as well as wages.
Our view is strengthened when we consider the state of the global economy. Global growth looks likely to increase by 0.8%. GDP growth in the G7 could accelerate a full percentage point to 3.7%. As a result, fund managers must be prepared for the consequences of central bank action outside the US. At the same time, they will also have to be prepared to suffer the impact of Fed action to date, namely the slow down in profit growth.
Being cautious means that we have had to do a lot of fundamental ‘soul searching’. We have concluded that although asset price valuations remain at historic highs despite the correction they can, to some extent, be justified by a lower risk premium than has traditionally been the case. We believe this is directly related to the impact of structural changes in demographics, globalisation and technology.
It is not just the equity risk premium that we have been discussing. We are also still trying to figure out what the equilibrium interest rate is. Higher trend growth in GDP and higher return on capital suggest that the equilibrium US real funds rate is not 2%, but rather between 3 and 4.5%. In Europe we feel that current real rates are too low and the neutral rate could be anywhere between 2 and 3.5%.
Despite having re-positioned our portfolios to reflect a more realistic old economy/new economy mix, we still feel that a market valuation disparity exists. We also see a voracious appetite for growth at any price and what can still be termed a lottery psychology (the willingness to pay more for a small probability of a large profit than is sensible) in the markets. In the light of this, one has to ask if technology stocks could correct again?
Within Europe we are seeing that the restructuring is gaining speed – spurred on by the desire to increase productivity. There is, however, a risk that structural rigidities in Europe will disappear slowly. Europe has been, and will be, slower than the US to adapt new technologies and there is a lot of catching up to do. This will mean that the ‘new economy’ transition may not be as large as promised – especially if things fail to reform labour markets.
In the US, productivity remains our predominant focus. In that respect, we are pleased to see that non-farm business sector productivity has averaged 2.75% since the mid-1990s, compared with an average of 1.75% over the previous 25 years and shows no sign of slowing. Continued productivity growth is key to restraining inflation!
In Japan our focus is on structural change. The restructuring evidence is mixed, but overall market conditions should imply meaningful structural change. We are following a new restructuring index, introduced by Goldman Sachs, and this shows an unbroken deterioration in restructuring from the mid-1980s until 1996. Since 1996, however, there has been a modest uptrend in manufacturing and a stand-still in non-manufacturing. According to the index, meaningful restructuring seems to be taking place in chemicals, electrical machinery and transportation.
Our asset allocation decisions this month have therefore been more structural in nature. We have targeted a lower underweight in the US, largely as a consequence of our deliberations on productivity and real interest rates.
Daniel Broby is chief portfolio manager at Unibank Investment Management in Copenhagen