Global equity market return has now been negative for six quarters in a row, except for the first quarter of 2001. This means that the downturn is almost as long as the 1973–74 oil crisis. The effects of the attacks are very difficult to quantify but growth forecasts are reduced and recovery postponed.
Equity market valuations relative to bonds are now at the low end of the range for the past 15 years based on forward-looking earnings. Earnings forecasts continue to be revised down, but can be revised down approximately 20% before the valuation of equities versus bonds is neutral. Our view on expected return for the fixed income markets in the coming 12 months are relatively low and equity markets are expected to outperform. US 10-year government bond yield is currently 4.6%, which is unusually low. Using the current long-term inflation expectation of 1.7% and required real interest rate of historical average 3.3% the bond yield should be around 5%. The worries are keeping the yield low in the short term but with a more stable environment and less risk aversion the bond yield will likely move higher.
As inflation is still low in a historical comparison we expect the positive correlation between equities and bond yields to stay in place for the coming year. In our scenario the effects of the attack on the economy is limited to a year, resulting in a normal economic downturn and then recovery by the second half of 2002. This means that earnings forecasts are likely to be revised down for another six months, leading to total revisions and expected return on equity being similar to the weak period of 1991–92. The factors affecting the economy positively are interest rate cuts, fiscal easing and the fall in oil price. Monetary growth relative to GDP growth has improved to above average from lower nominal growth, rate cuts and quantitative easing of monetary policy. The quantitative easing so far is about four times the amount during the LTCM crisis but half that of the Y2K period. The earlier regional differences in liquidity growth are now synchronised and above average in all regions. One way of judging if monetary policy is working is to watch corporate bond spreads narrowing. So far this has happened to high-quality bonds while low-rated bonds spread to government bonds is still high.
This scenario leads us to rebalance the portfolios back to neutral. The reason to increase the equity weight only to neutral is the current situation with war and unknown threats. We also see a period of very weak earnings reports and macro economic. The reason to rebalance anyway is that the markets might start to look through the current weak earnings and focus on the relatively low valuation and the prospects for recovery. The potential for very good returns for equities lies in a quick solution for the conflict, as this is not expected.
The risks for equity markets are that the attacks could lead to a longer period of weak growth and a delayed recovery. Further, if a widening of the conflict leads to higher oil prices the situation worsens considerably. The turn in US leading indicators was a good sign in the summer but now it is likely to turn down again. Mutual fund flows tend to follow performance and September resulted in outflows in most markets. The supply demand balance was in the short-term help by large buybacks of stocks from companies but if the market react negatively from more attacks fund flows will turn negative again and tip the balance as companies have limited ability to buy back stock.
The differences between the regional equity markets are small when it comes to relative liquidity growth and sector adjusted valuations. The change to free float of the global indices will create flows that are negative for the euro area and Japan while positive for the UK and US. This leads us to neutralise the regional positions in May and we will keep it until any differences occur. Stock and sector selection is currently focused on stable earnings growth and financials while a lot of research is done on cyclical areas to be ready to change to a pro-cyclical stance as the economy stabilises.
Jan Hillerstöm is in asset allocation research with SEB Invest in Stockholm

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