Pessimism about the outlook for the global economy have continuously increased in the past months and we now believe that the economic cycle will not trough before the first quarter 2002. We also expect the global recovery to be more shallow than previously thought and to start from a deeper trough. Our forecast for G7 real GDP is now for 1.4% growth this year and 2.2% next.
Subsequently, as world output will remain well below trend throughout the next year, this should put downward pressure on inflation rates. Overall, G7 inflation is forecast to fall from 2.3% to 1.8% between 2001 and 2002.
The weak economic recovery and lower inflation will make room for further monetary easing. Although most US economists believe the Fed is now on hold, it actually looks predisposed to do everything necessary to ensure growth. The ECB has started to cut rates and we believe it is now poised to cut by a further 50bps by year end. Japan has even started to print money with the monetary base now growing at 10% a year.
We are currently 5% under benchmark in equities compared with our maximum bearish positon of being 15% underweight. The key reasons for our misgivings about the short-term prospects for equities relative to bonds are:
(1) Usually a turn of economic growth is preceded by equities outperforming bonds. The most recent data of leading economic indicators don’t suggest unequivocally that macro momentum (earnings growth) is already beginning to turn. Only the US economy shows increasing signs of stabilisation. There is no such evidence in either Europe or especially Japan.
(2) Current equity valuations fall short of the type of readings associated with capitulation or levels of value that in the past have delivered excess returns: the earnings yield ratio (Ten-year bond yield divided by 12-month forward earnings yield) is now 1.05 versus recent capitulation levels that have typically marked the bottom of previous equity market lows of close to 0.9.
(3) Technical indicators are also sending strong signals that equities will go on to underperform bonds.
It has historically been hard to be a seller of bonds when the risks to GDP growth forecasts remain on the downside. Furthermore, we feel that there is still significant scope for positive surprises at the short end and on spot inflation. On the other hand, inflows into bond mutual funds are getting close to levels seen at other bond market peaks and our main fear is that bonds become slightly overvalued, suggesting that the bulk of the rally may now be over. Nevertheless, our fixed-income team remains slightly overweight portfolio duration (+0.5 years over benchmark), mainly through a long position in Euroland (overweight the 1-2 year and 7-10 year maturities) and, to a lesser extent, US treasuries (overweight the 3-6 year maturities).
In terms of regional allocation we are neutral. But, we enter a 5% hedge of USD holdings, since a long-term trend reversal is expected as the long-term downtrend of the EUR-USD was broken during the last few weeks.
The early years of economic recovery normally sees analysts understating the pace of earnings growth. In our view, this is unlikely to be the case going forward. For one, the global economy will struggle to deliver the strong rate of growth needed to drive a powerful rise in earnings. The second reason is profit margins are not at the depressed level they have been after coming out of previous slowdowns – leaving less headroom for expansion.
Within the global equity markets, we think the US region will be the most attractive.
Therefore, we stick to our small overweight outlook of US equities: Economic and earnings growth perspectives are better than in Europe and in Japan.
We stay benchmark weighted in European equities, where valuations are marginally cheaper than in the US and in Japan but on the other hand, the pace of earnings downgrades has accelerated over the last months.
In Japanese equities, we stay underweighted. Recent events indicate that the economy is once again plunging into crises and recent yen strength is bearish for corporate profits.
Wolfgang Leoni is managing director of Deka Investment Management, Frankfurt