Watch for the bumps in the road
There is mounting conviction in the markets that the synchronised slowdown in global growth – one of the worst on record – is close to ending.
The principle of ‘first-in-first-out’ keeps the focus firmly on the performance of the US economy. The news flow emanating from there over the last few weeks has been more positive than expected. The combination of substantial excess liquidity, a steepening of the yield curve, mortgage refinancing and a lower oil price has enabled consumer demand to shrug off the drag of rising unemployment and relatively high debt levels. Leading indicators such as the NAPM index and the SOX semi-conductor index seem to confirm that the manufacturing sector, which bore the brunt of the slowdown, has bottomed.
The key issue for markets now is to decide whether the remarkable resilience of the US consumer is
sustainable, or whether the surge in retail sales in the final quarter of last year ‘borrowed’ from subsequent quarters. While the rebuilding of depleted inventories is likely to produce a couple of quarters of strong sequential growth in the latter half of the year, it would appear that the markets are currently underestimating the risk that demand ‘double dips’ in the first half. The path to recovery is unlikely to be smooth.
An analysis of the other regional components of the global economy highlights the lack of a powerful engine of growth over the coming year. Japan remains mired in a vicious spiral of deflation, bad debts, a crippled banking system and an inept administration. The weakness of the Yen reflects the desperation of the authorities to inject some stimulus into the economy. The European recovery will be hampered by conservatism on the part of the European Central Bank and the lack of any co-ordinated fiscal response. The UK, which was a picture of relative stability in 2001 and is likely to deliver the best performance of the G7 economies this year, is in a global context, too small on its own to improve significantly the overall demand picture.
The risks to the outlook are that the combination of weak demand and excess capital stock could produce a deflation scare. We have also seen how a low nominal GDP environment stress tests business models. What does this backdrop imply for market returns?
Equity markets typically discount a recovery in the real economy by three to six months and corporate earnings by up to 12 months. We are confident that September was the capitulation sell off of this bear market and that those levels will not be retested.
Significant cash levels have been accumulated on both sides of the Atlantic which should lend support. However, the near 20% rebound in global equities from the September lows has made the markets vulnerable to disappointment with the trajectory of final demand and corporate news flow. If demand does dip then the rotation into higher beta sectors such as
technology and cyclicals could be reversed.
Equity valuations relative to bonds look attractive in Europe but still seem extended in the US – with the UK falling between the two. Although year-on-year earnings comparisons will become significantly easier as the year progresses, the US is unlikely to see a multiple expansion – it is transitioning from a value to growth cyclical valuation base. The Far East ex Japan offers the best leverage to a US recovery. Japan remains a recovery situation that requires a catalyst of change. The Yen needs to be watched extremely closely. A move above 140 against the US$ could negatively impact the Pacific region.
Bond market yield curves are forecast to flatten. While prices at the long end are expected to rally somewhat, the easing cycle at the short end is largely behind us. Money markets suggest US rates up at least 100 bps by the year end.
In conclusion, although 2002 will see a recovery in the global economy, the path will be bumpy and the end result will remain historically low nominal growth. While we expect equities to outperform bonds and cash, the total returns from all asset classes will be modest. As the year progresses, risk premiums should stabilise and we expect rapid sector rotation to persist within markets.
Our typical balanced fund is positioned overweight equities relative to bonds and cash. Within the global equity portfolio we would overweight Europe (attractive valuation) and the Far East ex-Japan (best leverage to the recovery). We are neutral on UK equities and underweight the US (high valuation). We remain negative on Japan (Yen weakness and awaiting catalyst of change).
Philip Lawlor is head of international equities at Royal London Asset Management in London