After a sharp rise in equity prices on the back of a so-called Technology, Media, and Telecom (TMT) boom, which began in October 1999 and ended abruptly in March 2000, global equity markets have been searching for directions and trading more or less sideways.
Investors have been searching for reasons to justify holding on to TMT stocks trading at historically high earnings multiples. The optimistic investors have been encouraged by the earnings growth potential of such companies as internet router provider Cisco Systems in the US, mobile phone carrier Vodafone of the UK, and wireless communication equipment manufacturer Nokia of Finland, just to name a few.
These are large players in the so-called ‘new economy’, which is widely believed to have helped sustain the tenth year of continuous economic growth in the US with little inflation amid rising productivity. They have indeed become very dominant in their respective markets. Cisco Systems, which makes up more than 3% of the S&P 500 index, has a market capitalisation of $ 400bn, almost as large as the entire Canadian or Dutch stock market. Vodafone has a market capitalisation of around $ 230bn and makes up 11% of the FTSE 100 index. Nokia, with a capitalisation of $200bn, is a proxy for Finland anyway.
Such TMT players are still setting the tone of US and European, and Far Eastern equity markets.
While the US and European stock markets are hovering at a high level, the global economy has been growing steadily but there are some signs of peaking. The Japanese economy is growing again finally, thanks to large economic packages totalling 120 trillion yen or roughly $1 trillion injected by the Japanese government into the economy since 1992, and the zero rate policy that has just recently been reversed.
The good news is that both Japan and Europe have embarked on large corporate restructuring programmes, leading to many cross-border merger and acquisitions, especially in Europe. The bad news is, while economies world wide have rebounded, so have the commodity prices, especially the oil price. At the same time, both the Fed and the ECB have raised rates many times since the Russian crisis in 1998, to pre-empt inflation induced by buoyant economies.
Investors world-wide are now monitoring the likelihood of a soft-landing in the US and Europe, whereby the economy slows down to trend level with manageable inflation and no obvious negative impact on corporate earnings.
Relative to global bonds, we have turned slightly more positive on global equities, which are dominated by US equities. The US makes up about 50% of the MSCI World Index. In fact, the developed markets of North America, which includes Canada, make up around 54% of the MSCI World index, and Europe, consisting of Euroland, UK, Switzerland and Scandinavia, represent another 32% of the index.
The rest is the Pacific, which comprises to a large extent Japan, and smaller markets like Australia, Hong Kong, Singapore and New Zealand.
While a euro-based investor who had diversified into global funds has seen some handsome returns due to the weakness of euro relative to dollar and yen, any rebound in euro in the medium term may offset some of the returns of global equities when converted back into euro.
Going forward the investment themes are dominated by the earnings growth expectations of TMT stocks, the possibility of a US and European soft-landing, oil prices and the outcome of the US election. Although internet and wireless communications related companies are still expected to grow rapidly, further earnings growth from a high base may become more challenging. While oil prices are expected to play a smaller role in an increasingly service oriented economy, any future imbalance in oil supply and demand, especially in the US in the coming winter may become a drag on market sentiments. On the other hand, the forthcoming US election is likely to generate some excitement and at least a ‘soft guarantee’ from the Fed not to raise rates, and the market may well rally in the fourth quarter, as fund managers plough their cash back into the market. The US election is probably not going to result in any major change of policies other than healthcare, which may affect the pharmaceutical sector. While we are aware of the down side risks of higher oil prices, these have been largely factored into the market. The recent economic data from the US and Europe also show the economies cooling off a little. There may be some short term nervousness in the market about earnings disappointment resulting from high base comparison and a one-off Y2K effect, and imbalance in oil supply and demand during the coming winter may not help either.
However, the longer term prospects for equities are still positive as the global economy benefits from a soft-landing in the US, and the rest of the world catches up with the US on financial deregulation, pension reform, corporate restructuring and technology enabled productivity improvement.
Beyond the developed markets, we continue to be positive on emerging market bonds due to reduced risk aversion arising from booming commodity and oil prices benefiting many emerging economies and growing expectation of a soft landing in the US. We are also moving back into emerging equities in anticipation of a possible rally, as investors move back to this asset class on attractive valuations relative to other asset classes and on historical comparison, barring any setback in the US and Europe.
Hean-Lee Poh is a senior asset manager at WestAM in London.
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