Equity and bond markets have exhibited heightened volatility in the aftermath of the terrorist attacks in the US. The slowdown in global economic activity since the beginning of this year and the associated deterioration in corporate profits growth has caused equity markets to fall sharply, leaving equity valuations at attractive levels. The aggressive fiscal and monetary response to an inevitable US recession has prompted markets to discount a strong recovery in the US economy. In contrast, fixed interest markets have delivered the best returns since 1998 and look fully valued. We expect equities to outperform both fixed interest and property in 2002.
The strong rally in equity markets since the atrocity in the US suggests that equity investors are confident that the monetary and fiscal policy response by the US authorities will be enough to cause a strong bounce-back in the US economy in the short-term. We are more circumspect. We do not expect evidence of a recovery to come through until the second quarter of 2002.
Our central scenario is for a mild US recession to be followed by a mild recovery. Despite our below consensus view on growth, we still expect equities to be the best performing asset class in 2002. Swings in inventories have been a key driver of volatility in past recessions. The slightly desynchronised nature of the current US economic cycle (with the stock downturn happening prior to a full-blown recession), is likely to result in a milder cycle compared to the past. Despite expecting further large and significant declines in personal consumption and private investment, this business cycle should be more muted compared with previous recessions. The mild upturn we expect does not suggest outsized gains in corporate profits.
The reflationary policies being implemented in the UK and Europe should allow this region to avoid a recession. The Bank of England’s monetary policy committee’s (MPC’s) 2.5% target inflation rate is above the upper limit of the European Central Bank’s (ECB’s) 0–2% range. This suggests the MPC has more flexibility to decrease interest rates and boost demand. We expect economic growth of 1.7% in the UK next year and 1.4% in Continental Europe.
As Japan experiences its fourth recession in a decade, the economic growth outlook appears dismal. With limited options available to the authorities to boost the ailing economy, (interest rates are already at 0% and there is a commitment to maintain the ¥30trn government spending cap), the Japanese economy will struggle to attain positive growth even in 2002. In the rest of Asia, in addition to the weaker export outlook, tourism will be adversely affected. However, increasingly proactive monetary policy and a lack of financial gearing should limit the downside from weaker exports in the region. An economic recovery is expected next year and investors should increase their risk preference levels, boosting Asian and emerging stock market exposures.
The anticipated slowdown in the UK economy is likely to have a negative short-term impact on the property market. However, we are more positive on the medium-term outlook. High levels of yields look increasingly attractive relative to equities and government bonds. Over the next three years, property is expected to generate an average return of around 9.3% pa.
In currency markets, we favour the euro. We expect the yen to trade within $/¥ 117–127 range over the next year with any yen appreciation met by government intervention. The outlook for the pound is muted. Higher interest rates in the UK relative to the US and Europe next year will keep the pound well supported.
In summary, equities are likely to deliver returns of between 10–15% in 2002. Property is our next most favoured asset class with the return expected to be 7.7% next year. The economic recovery in the second half of the year suggests bonds may struggle to deliver 5% returns.
In 2002, key risks to our forecast are on the downside for economic growth and equities. These include the possibility of further terrorist attacks and the ongoing anthrax scares, which continue to undermine consumer confidence. Furthermore, the degree of synchronisation of global economies is higher than during previous downturns. This increases the probability that the global downturn is deeper than we currently anticipate.
Adrian Jarvis is head of strategy at Morley Fund Management in London

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