Politics back on the agenda
After the sharp spring rally in stock markets, equities marked time over the summer before surging higher into September. The summer was dominated by the spectacular bursting of the bond market bubble, with volatility now beginning to calm down. As we move into the autumn, we consider the next key moves for the world’s financial markets.
Starting with bond markets, why did a bubble appear, why did it burst and what are the consequences? There is usually a kernel of truth supporting any bubble. For example, the internet has transformed the way in which business is carried out. Similarly, base rates will remain low in a low-inflation world, reacting to the investment excesses of the 1990s and the expansion of Asian capacity. The more alarmist arguments about global deflation are wide of the mark though. Central bankers have continually warned that the risks are low and they are ready to step in with unconventional policies. When the bond bubble eventually burst in June it was sharp, sparking the largest one-month sell-off in US bonds in a decade. Investors are waking up to the political cycle, with President Bush looking ahead to re-election in 2004. Retail sales in the US are starting to see the benefits of the tax package, while the White House has admitted that the budget deficit could reach a record $475bn (e421bn) next year. In Europe, Gerhard Schröder has reached a provisional agreement for German tax cuts worth some e18bn. France and Italy are similarly taking action which in effect tears up the stability and growth pact. Who pays for all this largesse? Yes, the bond investor!
If a bull market in bonds has ended, will a sustained bull market in equities begin? Certainly, equity markets have made good progress since the start of the year. The FT All Share is up about 12%, the S&P 500 16%, with the Nikkei 24% higher. Rather than examining performance data, it is just as important to examine the changes in market psychology. A classic market cycle goes through phases: over-optimism, greed, fear, panic, demoralisation, reflection and, finally, renewed interest. Recent months have seen renewed interest by equity investors. Markets are reacting far less violently when a company does report bad news. The breadth of sectoral movements compares favourably with the narrower rallies seen during 2001 and 2002. The more adventurous investor has begun to look further afield, among emerging markets and Japanese equities, for signs of global reflation.
The foundations for an equity market recovery may not yet be rock solid but they are firmer. Investors are once again focusing on corporate and economic fundamentals. There are risks, for example whether the jobless recovery eventually causes consumer spending to roll over. While the upturn in global growth has broadened out from the US to include China and Japan, Europe remains more of a drag. More positively, narrower corporate bond spreads show that monetary policy has begun to work for the company sector, just as it has kept the household sector afloat. Profits growth exceeded expectations in the first two quarters of the year, and strong productivity data suggest that the estimates into year end are achievable. Finally, companies are focusing on shareholder value, as shown by a wave of corporate restructuring and M&A activity.
In the light of our view that policy- makers are more likely to achieve a period of reflation rather than allowing deflation to appear, our portfolios exhibit a strong bias towards equities and away from bonds. We are overweight in UK equities and US equities as corporate earnings continue to exceed expectations and the potential for upgrades is likely as revenue growth starts to feed through. We are also heavy in Pacific Basin equities, as the region should benefit from growth in world trade and valuations remain reasonably attractive. Despite the continuing structural problems faced by Japan, we recently increased our weighting in Japanese equities. The world’s second largest economy is benefiting from the pick-up in world trade while more sectors of the market are becoming attractive as earnings beat expectations supported by strong business investment. Lastly, of the major stock markets, we are underweight in European equities as economic news remains weak, the stronger euro is pressurising exporters’ profits and the response of policy-makers has been less flexible than elsewhere.
For similar reasons, our favoured bond market is the Euro-zone. Although unlikely to outperform equity markets, we believe that Euro-zone bonds should perform better than other bond markets, as the lack of inflation keeps interest rates lower for longer. Of the other regions we prefer Japanese bonds to UK and US bond markets, as we are confident that currency appreciation will sustain demand for Japanese bonds. Investors are beginning to search for value in the US and UK bond markets after the summer sell-off, but more attractive valuations must be offset against the realisation that monetary policy will eventually be tightened as the economic recovery broadens out.
Andrew Milligan is head of global strategy at Standard Life Investments in Edinburgh