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Sink or swim?

It is crunch time for the global economy. What happens over the next couple of months could well determine whether the global economy sinks or swims in the first half of 2003. The recovery that began earlier in the year has clearly faded and the most recent economic data has been a bewildering mix of good news and bad. Conflicting forces are at work. The restructuring of balance sheets is exerting a downward pressure on demand. At the same time, a move to a more accommodative fiscal policy and a sharp drop in the yield curve will support activity. Although evidence is not yet compelling, the powers of reflation look likely to win this particular battle.
In the US, figures for October have been slightly worse than expected and indicative of a poor start to the fourth quarter. US production is now contracting, demand growth has turned lower, business investment and employment growth are both virtually flat and money supply growth appears to be slowing. But there’s good news too. The housing market remains exceptionally strong – new home sales have soared, reaching new highs in September and housing construction growth is stronger than it has been in years.
US consumer confidence fell sharply to a nine- year low in October, clearly undermined by falling share prices, the threat of war with Iraq and the uncertain outlook for the economy. But deteriorating confidence does not always translate to a curbing of spending – during the 1997–98 financial crisis and post-11 September spending growth continued to rise despite declining confidence surveys. 1, consumer demand has looked weaker over the past couple of months but the US consumer has been remarkably resilient this year, given the ferocity of stock market declines and labour market weakness. Going forward, the US Federal Reserve’s half-point rate cut and the recent surge in share prices should boost confidence and keep consumers spending.
Although business investment remains flat it has at least stopped deteriorating. A turn in the US investment cycle may not be far off. Despite some disappointments, corporate profits are generally improving – US productivity is rising relative to labour costs for the first time since the early 1990s and this is a clear positive for profits. Capital spending tends to lag profits growth, so the return to corporate profitability is a good sign for investment.
In Europe, the ECB’s decision this week to leave interest rates on hold was hardly surprising given the central bank’s reputation for inaction, but disappointing all the same. Growth continues to slow in the Euro-zone, domestic demand is deteriorating and is close to zero growth – Germany and Italy are barely growing at all. If monetary policy remains this tight for much longer, there is a considerable risk the Euro-zone economy will slip into recession. What’s more, growth and inflation differentials between Germany and the continent’s smaller economies continue to grow. There seems little hope for Europe’s largest economy until labour costs move closer to the European average.
October was a surprisingly good month for stock markets. By the time Halloween came around, US markets had given their best monthly performance in 15 years – the Dow gained almost 11 % over the month and the Nasdaq more than 13%. Many of the world’s major stock markets experienced gains on a similar scale. This recent rally in equities has sparked an improvement in confidence, particularly among retail investors. While geopolitical uncertainties continue to make investors uneasy, markets have taken comfort in President Bush’s seemingly more diplomatic approach to Iraq. That said, we are unlikely to see a sustainable rally in equities until economic data dispels fears of a more protracted period of economic weakness.
At last, there is a glimmer of hope in Europe. While the economic outlook for Europe is far from sparkling, the outlook for markets in the region is brighter thanks to a significant improvement in valuations (courtesy of lower share prices) and signs of a pick-up in European money supply growth. Elsewhere, prospects for markets on the Asian mainland are also improving – equity markets there have drifted lower since July and valuations are subsequently more attractive.
Equity markets are looking more reasonably valued than they have done in quite some time. Although on a historical basis equity valuations are still a little high, a revival in earnings seems likely over the next six months. On a relative basis, equity valuations are attractive. Bond yields have fallen sharply and are discounting weak growth – if the more positive scenario for the global economy does pan out, bonds are looking overvalued at current levels. But current equity valuation levels are only attractive if (and a big if) correlations with bonds normalise. This should happen if earnings do revive.
Mike Collins is head of asset allocation at Pictet Asset Management in London

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