Under the current economic scenario it has generally been right to favour equities over bonds. In 20...
Under the current economic scenario it has generally been right to favour equities over bonds. In 2000, however, cash and bonds both performed better than depressed equity markets.
Despite the expectation of a slowdown in economic growth, the consensus view is that the rates of growth will not slow sufficiently to risk recession. Accordingly, we need to ask whether 2000, with bonds performing better than equities, was an exception to an otherwise appropriate investment stance, or the start of a necessary correction from the excesses of an extended bull market.
Looking at equity markets, some analysts regard them as undervalued compared to bonds and cash, especially after the 50 basis point cut in the Fed fund rate in the US. This is fine if the usual caveats apply. If the market is willing to adapt to the reduced returns from slower growth in nominal GDP, then higher levels could be attained and maintained. On the other hand, markets have been unwilling to settle for the level of return that might be implied by the growth in the economy.
In the UK, many brokers believe equities will bounce back strongly in 2001 and will have gained considerable comfort from the US interest rate cut. However, earnings growth assumptions are more restrained, implying rising P/E ratios to previous highs, despite the less favourable economic conditions.
The desire for high returns from equities is understandable and interesting - but might equity markets have to be able to extrapolate higher and more visible returns than are currently realistically on offer? If markets want returns nearer 15% a year, they might only be able to achieve this by first letting share prices fall sufficiently to allow a natural catch up.
The avoidance of a hard landing in the US looks to be the key signal to markets, although it may be more supportive to Asian markets than in the US or Europe. Markets are certainly putting considerable faith on the Federal Reserve's ability to manage the cycle and this is being priced into markets earlier than usual. The Federal Reserve was seen to have saved the day in 1998, but on that occasion, interest rate cuts added fuel to an already rampant consumer.
Currencies could determine a large measure of the total return from individual markets this year. The US dollar is perceived to have benefited from higher growth in GDP and productivity than in Europe. This is no longer the case and better short-term fundamentals in Europe are widely forecast to help the Euro. For sterling investors, this suggests Europe could provide some of the best returns this year.
If the dollar shows continued weakness, this would be another reason for UK investors to stick with the domestic market that has a relatively defensive earnings stream. Japan remains as difficult to predict as ever and the yen is looking pretty friendless.
Tim Rees is director, UK Equities at Clerical Medical
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