Already in the eighth month of the current slowdown, the fact that the average post WWII recession has lasted around 11 months means recovery could be round the corner
When looking at the investment outlook for 2002, the first question to consider is whether or not the bear market in equities has finally ended. Having enjoyed an extended bull run during the 1990s, markets peaked in March 2000. The damage to investors' wealth since then has been considerable. The World Equity Market Index has lost about one third of its value, a similar decline to the 1973-74 bear market.
Whether the recent rally does mark the end to the bear market will depend on how investors address certain issues in 2002. First, are equity markets now sufficiently cheap? We think so ' the series of rallies during 2001 were aborted because stocks were still expensive in relation to other asset classes. The good news is that the recent sell-off to the lows seen in September 2001 did create value for a broader range of stocks, which encouraged long-term investors back into the markets.
A second issue is the outlook for inflation or, more precisely, the lack of it. Throughout the 1990s, analysts raised their expectations for medium-term profit growth, despite simultaneously lowering their inflation expectations. This reflected the extended business cycle and the ability of the US economy, in particular, to raise productivity growth rates to historically high levels.
During the last few years however, low inflation has caught up with companies' ability to meet those profit expectations. The share of profits in the US economy peaked in 1997 and fell back slowly thereafter. Equity investors have begun to lower their long-term expectations and revalue shares accordingly but the process is still ongoing.
The bear market in equities during 2001 foreshadowed the rapid deterioration in the economic outlook. The downturn was erratic, as an industrial recession in the technology sector in the US and Asia slowly spread to other sectors and countries.
Since the autumn, it has been clear that the world economy was entering the first synchronised recession since the early 1970s. We expect a notable economic upturn into 2002, as there has been a substantial policy reaction around the world in response to the global recession. The extent of policy easing has varied from country to country, with the most aggressive moves coming in North America and Europe, but the net effect has been dramatic.
Interest rates have been cut to their lowest inflation-adjusted levels for a decade, while the UK is enjoying the lowest nominal rates for 40 years. In addition, there has been a considerable degree of fiscal stimulus, causing bond markets to worry that the series of budget surpluses in the US and UK could rapidly disappear.
Energy costs will also be supportive. Last winter, expensive natural gas and heating oil costs were a major squeeze on businesses and households in North America and Europe. Contrast that with this winter ' Opec has finally lost control of the oil price, which has fallen below $20 a barrel for the first time since early 2000. This will provide a helpful impetus to economic activity.
The downturn in 2000-1 was unusual because the collapse in demand was focused on the corporate sector rather than the household and we think this divergent trend will continue. Business investment is unlikely to recover for some quarters, as companies face excess capacity. Conversely, lower interest rates, sizeable tax cuts or public spending programmes, plus lower oil prices, should all support consumer spending, despite the inevitable round of redundancies seen in the final stages of a recession.
The terrorist attacks on 11 September constituted a body blow both to the equity markets and the global economy. However, they also brought forward the turning point for markets, causing heavy selling by weaker financial institutions and panicking investors. We believe that the aggressive policy reaction will prove to be crucial.
Liquidity is flooding the capital markets as shown by the spate of rights issues, corporate bond and convertible issues in recent weeks. As a result, we are likely to see a more vigorous turnaround in markets than would have been the case without the terrorist attacks. We have already witnessed a dramatic rally in equities since 21 September, while bond yields have fallen sharply in recent weeks as investors actively seek riskier assets.
Investors are already looking beyond the next quarter or two, which they know will be bad, in expectation of an improving trend by about the middle of next year.
This approach has been supported by some positive news, in the form of commodity prices, freight costs, business sentiment surveys, all suggesting that companies are becoming more positive about the outlook. Seasonally, equity markets often perform well over the winter months.
With the additional benefit of extremely favourable monetary conditions, we expect them to move higher in the coming months. Which sectors of the equity market could perform well in these circumstances? Investors have already been moving out of defensive stocks into cyclicals, partly on valuation grounds and partly on expectations of a recovery in demand. This trend has further to go as more investors realise that the authorities will successfully engineer a recovery in activity.
A surge in liquidity from the central banks has also encouraged a rebound in second tier stocks, as investors have priced in their continued survival rather than imminent bankruptcy. The corporate environment will continue to be risky going forward though with pricing power at a premium.
Turning to bond markets, during 2001, evidence of the first major recession for the major economies in a decade supported lower bond yields. Looking ahead, the combination of economic recovery, deteriorating fiscal positions in several countries and heavy corporate bond issuance as companies restructure their balance sheets, all mean poor news for bond investors. We believe bond investors have probably seen the best of this investment cycle.
While the outlook is less favourable, it is by no means bleak. The severe bruising many investors suffered during the deflation of the tech bubble has caused them to become more conservative in their attitude to risk.
In a low inflation world, the demand for yield certainly encourages purchases of corporate bonds. In the UK, accounting practices and solvency rules still encourage pension funds to switch assets in the same direction. These structural factors will mitigate the extent of deterioration in yields, but nevertheless, the investment cycle is clearly turning away from fixed interest assets.
Recently the US has been officially declared to be in recession. The good news is that typically a recession is at least half over before it is declared and we expect the economy to be recovering before long. The average span of a recession in the post-WW2 period has been 11 months and the current slowdown is already eight months old. We are looking forward to a renewed cycle for the equity markets as we move into 2002.
The World Equity Market Index has lost a third of its value since March 2000.
The bear market in equities during 2001 foreshadowed the rapid deterioration in the economic outlook.
The net effect of the global policy reaction to the slowdown has been dramatic.
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