After roughly 18 months of monetary tightening, the world has embarked on an aggressive easing cycle. Indeed, official rates were lowered 26 times around the world between early December and mid-February. The current easing cycle is bound to continue in the near future, as the world economic cycle has not reached its trough yet and as inflationary pressures remain virtually absent.
Following the oil shock and past monetary tightening, the world-wide inventory correction is still to come and the slow-down in technology activity has just begun. On top of that, in the US, balance sheet imbalances need to be corrected both for household and corporate and are likely to bring about 1.5% GDP growth in 2001, with slight negative growth early in the year. In Japan, the recovery in corporate investment is due for a halt, and the economy is on the verge of yet another mild recession. The British economy is likely to suffer from the international downturn.
Finally, despite expansionary fiscal policies and resilient household confidence, the Euro-zone is also in for a slow-down, although more moderate than in the US. So far, among major economic areas, only the Euro-zone has not joined the party of monetary easing, but our perception of the economy leads us to think that it is just a matter of time before the ECB joins in.
In such a rather negative fundamental environment, financial markets are bound to weigh the risks of a significant downturn against the favourable prospects of aggressive monetary easing and of a resulting steepening of yield-curves. To date, we feel that the bond market is not fully discounting the amount of monetary easing required in order to kick start the economy, namely in the US. After the 100bp easing in January, the Fed is likely to go on decreasing rates, though at a more moderate pace, bringing the Fed fund rate to about 4.25% by summer. The Bank of England should follow on by lowering the official rate to 5.50% or even 5.25%. We also expect the ECB refinancing rate to hover at about 4.25% by summer. As a result, the bond market should go on performing in the next three months, with 10-year government rates going down to 4.85% or so in the US, 4.65% in Germany, and 4.55% in the UK. The Japanese bond market is expected to remain rather rangy. Hence, the US bond market is likely to be the best performer of all major bond markets.
But despite this expected improvement expected on the government bond market, the main investment bet today on a three-months horizon seems to us to be on more risky assets. The stock market is in for another month or so of volatility and new lows are possible, if not probable, especially on technology stocks. We do expect further bad news to come, but not necessarily more bad surprises. Indeed, any bad news on the economic front is likely to increase the probability of further easing by monetary authorities and to be, at the end of the day, regarded positively by the stock market. On top of that, cash holdings remain high and liquidity is ample. We feel that the most important event to wait for might paradoxically come from Europe, where the ECB has not yet acknowledged the extent of the slow-down. Hence, any sign of imminent monetary easing on its part could prove the right trigger for the euro market. As we do expect such a move to occur within the next three months, we do feel that the European markets are the best opportunities at such a horizon. We keep the Japanese market underweight, as it remains weakened by poor economic fundamentals and a dramatic political situation.
On a sector point of view, we have kept a rather neutral stance on a short-term horizon. On the whole, the market is not far from being fairly valued but high potential stocks remain over-valued and stocks that are expected to benefit the least from the favourable monetary environment are rather under-valued. The next move will be to come back on cyclical and carefully selected technology stocks, as they should be the main beneficiaries of monetary easing and steeper yield curves.
To sum up our views, we recommend adopting an overweight position in equities, with euro markets the best performing group among the major four. But we would also to a lesser extent favour the bond market through an extended duration, mostly on the US market.
Roland Lescure is deputy head of strategy at CDC IXIS Asset Management