The July equity crash has disrupted relative asset valuations, but it will not be possible to measure them with any confidence on a prospective basis until markets stabilise somewhat and allow us to assess the impact on the whole economy and on specific industries.
The pervasive crisis of confidence prompted us, from June 11 onwards, to change the equity exposure of most balanced accounts from a slight overweight to underweight, mainly at the expense of the US market. Euroland, and to a lesser extent Japan, remained overweight, and the UK and Pacific Rim roughly neutral. The emerging market exposure stayed focused on central Europe and Russia. In industry terms, most cyclical groups were scaled down, as well as technology. Except for retail banking, financials were reduced further.
The reduction in equities was done in favor of cash and, where applicable, alternative investments. Bonds remained slightly underweight in balanced portfolios, with some diversification into investment-grade corporate issues. Euroland and converging central Europe stayed overweight at the expense of US and Japanese issues. In addition, for non-dollar-based portfolios, part of the overall dollar exposure had been hedged since early May.
While the 2000-2001 equity bear market was in response to the latest economic recession, we would argue that the recent market crash was disconnected from economic fundamentals.
In our opinion, the new economic cycle had been unfolding according to the usual pattern. By mid-2002 a stage was reached where US corporate profits started to recover significantly thanks to improving sales volumes, diminishing pressure on selling prices, and falling labour costs. The market crash that followed has apparently brought many stocks and indices into undervalued territory. To confirm this judgment, however, we must be sure that our earnings forecasts are achievable.
Is the crisis of confidence severe enough to derail the world economic recovery that is now underway? In other words, even though economies were not the cause of the crash, could they become a casualty?
Our answer to that momentous question is negative, but with qualifications. We expect consumer spending to be resilient enough to keep the US economy afloat. Confidence has been badly shaken but the widely-heralded wealth effect has not been negative, as strong housing prices have offset the quite severe drop in equity values for most households. With some exceptions, house prices do not appear to have reached excessive levels relative to interest rates, income growth and demographics.
Although monetary conditions will remain quite easy worldwide, hefty credit spreads can still push overleveraged companies into bankruptcy. But that leverage had been achieved by bond issuance rather than bank loans, spreading the risk among many market participants. Compared with past crises, the world banking system does not look extremely strained, which limits the risk of bank failures and of a major crisis of confidence among the general public. Still, the financing squeeze is causing a severe blow to business confidence. Capital investment in the US looked like bottoming just before the market crash, consistent with the improvement in corporate cash flows. But now, market conditions will probably delay its recovery.
The fall of the dollar is an additional concern for European and Japanese manufacturers. The dollar is not just a bellwether of investor confidence: international capital flows had started to turn less positive for the US many months before July, in response to worstening Federal finances, weaker political leadership and accounting scams. We expect the dollar to pause near current levels, but its downtrend will probably resume over the medium term.
Equity market weakness to the end of July had prompted us to revise our forecasts, especially for nominal GDP and corporate earnings growth, but our broad scenario remains in place, ie, growth expected to become more balanced in geographic and industry terms, with manufacturing output accelerating and capital investment bottoming out. That would logically be positive for US multinationals, domestic-oriented European stocks, most Asian markets and technology worldwide. Even though inflation is not a concern, government bonds would then react negatively to the improved growth outlook.
However, we are not quite ready to shift our allocation back in that direction yet. In the event that world equity markets fall further and stay weak for quite a while, growth would remain subpar and almost exclusively consumer-driven in the US, Euroland would take longer to recover, and Japan’s bounce would abort. It would still fall short of an overall ‘double dip’, but the world economy in 2003 would look much like 2001: unbalanced and shaky, with the dollar being an additional negative. All this would call for keeping a fairly defensive allocation.
In the weeks ahead, some bottom-fishing of individual stocks is in order, but before making greater changes to our policy, we want to be able to confirm the scenario described above. Forthcoming economic data will soon allow us to measure the impact of the July crash, and the equity market itself will be a key variable.
Patrizio Merciai is a chief strategist at Lombard Odier Darier Hentsch Group in Geneva