It seems the global cycle is far from dead. It is clear now that global activity both in terms of GDP and industrial production peaked in the second quarter of 2000, and has been slowing ever since. OECD leading indicators have been falling since the end of 1999 and you neglect these at your peril. More importantly, this slowdown is likely to be synchronised, with the increasing globalisation of markets over time and the ever-increasing share of exports and imports in GDP.
The biggest adjustment to growth is in the US where, after nine years of economic expansion averaging 3.8% (with the most recent five years averaging 4.4%) consensus for 2001 is moving towards 2%. In Europe, 2000 delivered the first above-trend growth for a decade (3.4%), but last year’s rate hikes, combined with slower world trade, will see growth soften to less than 3%.However, this will be above Europe’s 10-year average growth of 2%.
A sharp slowdown in US demand is generating renewed concerns about Japan’s infant recovery. Industrial indicators, which had risen since the 1998/99 lows, have recently turned down, and consumption continues at best to be sluggish.
Our view is that we are going through a milder version of events similar to those of 1998. Then the Asian crisis and LTCM fuelled a rise in risk aversion and a retreat from risky assets. But interest rates were cut quickly and pretty soon we were on an upward growth trajectory again. This time the collapse in the Nasdaq (down 50% from its peak) has generated similar concerns and the prices of risky assets – high beta stocks, low-grade corporate bonds and emerging market debt – have fallen sharply, while government bonds have risen.
The biggest issue for investors is whether the present pessimism is justified or is it irrational. A slowdown to a more sustainable pace of economic activity is no bad thing, and the rises in interest rates in 2000 were small in an historical context. Lower rates, accompanied by lower bond yields and easier fiscal policy, could result in a stronger recovery in the latter part of 2001. A full-blown credit crunch, however, would lead to a recession accompanied by a significant slowdown in investment spending and consumption. Equity prices would drop even further, causing steeper declines in wealth and demand.
We believe that central bankers will work hard to stay ahead of the curve. The US Federal Reserve has already moved with its unexpected 50 basis point cut in rates. We believe a further 75bps and a fiscal policy response from Congress will help to stabilise sentiment. The UK and Euroland are also likely to cut this year; we are forecasting at least 25bps in each area. Provided the world doesn’t go into deep recession we believe that investors should prefer equities to bonds in balanced funds.
Historically, when the Fed moves from a stable interest rate policy to an easing one, it is one of the best times to buy equities (for example, 1984, 1989, 1995). Once the Fed has eased rates twice, investors have greater confidence to look through the ‘mists’. At this stage of the cycle investors buy stocks despite the fact that eps growth is falling. Our models indicate that the valuation of equity markets is at fair value, are oversold in some areas and that sentiment is on the floor. Falling bond yields have so far cushioned the blow of profit disappointments on valuations, particularly in the non-technology sectors. For our managers to go overweight in equities we require indicators that central bankers outside the US are about to join Fed easing, together with signs that leading indicators of growth are bottoming out.
In equity portfolios, as the bad news has been priced in, we have increased our weightings in the US and UK. We are neutral in Europe, underweight in Japan and we are looking for an opportunity to increase our Hong Kong exposure (given its sensitivity to lower interest rates). Among sectors, we are moving from a defensive to a growth bias. We are selectively buying technology and telecom stocks. Pharmaceuticals and healthcare, while expensive, do provide some defence against further earnings disappointments. We are neutral on financials with selectivity being crucial in all regions.
The scale of the slowdown in the US has led us to reduce our exposure to the US dollar. If the slowdown heads towards 2% in the US then the euro could move above parity versus the dollar. The relatively good UK data should continue to support sterling.
The early aggressive Fed easing should produce a payoff by mid-year for world economic activity, provided it is followed by other central banks. Investors have recently been focusing more on the risks than rewards in markets. The change in monetary policy, with the prospect of fiscal loosening, reduces much of the liquidity and economic risks. Move portfolios to overweight equity positions with a well-diversified growth bias for 2001.
Emmett Dunleavy is senior investment strategist at Hibernian Investment Managers in Dublin