The longer-term outlook for equities should be broadly positive, although there could be a period of consolidation after the recent short-term rises
Last year was particularly difficult for equity markets, with concerns about global economic growth and corporate earnings being compounded by accounting irregularities and the prospect of military action in the Middle East.
Over the course of 2002, the global economy showed tentative signs of recovery but the strength of the recovery fell short of investors' earlier expectations. The US economy has shown an erratic growth pattern as measured by quarterly GDP.
In the US, third-quarter GDP beat expectations, with the economy growing at an annualised rate of 4%.
Although the US consumer supported growth, as did government expenditure, business investment has remained low and the current quarter is expected to show little growth.
However, forward-looking indicators of growth and confidence have started to improve in the US, which should lead to improved indications in early 2003.
In the UK, consumer confidence and spending held up well over most of the year, although there is now some anecdotal evidence of slowing. The robust housing market has been another positive.
The manufacturing sector suffered during the downturn however and is just beginning to improve, while many small companies continue to suffer from difficult global trading conditions as well as currency issues.
Europe, in particular the eurozone, endured difficult conditions throughout most of 2002. The European Central Bank (ECB) has shown much less flexibility in its policy, focusing on its mandate to control inflation rather than taking action to stimulate growth.
Although the target date for governments to balance their budgets has been pushed out, the ceiling of a 3% deficit is already having an impact on spending and taxation decisions that are acting to reinforce rather than counter cyclical pressures.
At the time of writing, Japan had finally managed to return to some modest rate of economic growth but forecasts for 2003 are being revised down. The bad debt problem in the banking sector remains to be resolved. Despite encouraging signs from the government this autumn, concrete evidence of measures to resolve the issue has yet to emerge.
In South East Asia, while the slowdown in the global economy had a negative impact through a large part of the year, exports were rescued by growth in the level of trade within the region.
The economies in the region are now relatively robust, although the threat of further terrorist attacks following Bali means that revenues from tourism are likely to be reduced in the short term at least.
Uncertainties over the strength and durability of an economic recovery and the extent to which corporate profits would respond have contributed to the weakness in equity markets. Fixed income markets have been those favoured by investors, although in the corporate bond market only the stronger rated bonds have performed well.
The weakness of corporate profits and the extended balance sheet of a number of large issuers have led to ratings downgrades and defaults for weaker credits. Currently, falling tax revenues will lead to an increased supply of government bonds as we have seen in the recent pre-budget report in the UK.
This is not likely to affect yield while investors seek security of income, but when confidence in equity markets returns, this may change.
Equities globally suffered a period of great volatility. Disappointing company results and profit warnings continued to emanate from a diverse range of companies, leading to further reassessments of valuation levels.
Investor confidence was undermined by corporate accounting issues, as US companies WorldCom and Xerox reported accounting irregularities, and the energy trading giant Enron collapsed.
This dented investor faith in the integrity of accounting practices, particularly in the US, setting a cautious tone for the remainder of the period under review. In the UK, the market was also hit by fears that life and pension funds offices would be forced to sell equities due to the weakness of equity markets.
We believe that the longer-term outlook for equities remains broadly positive ' although markets have risen fast in the short term and a period of consolidation may be necessary.
The backdrop for a global economic recovery is encouraging. Interest rates both in the UK and US are at historically low levels and medium-term inflation is under control. While the European economic background may not be as robust, the 50 basis points interest rate cut showed a more flexible approach from the ECB. In the US, the Federal Reserve is committed to promoting growth and will take further policy actions if the economy does not respond.
The UK economy remains one of the fastest growing of the major economies and has been robust in the face of a global economic slowdown. Inflation and interest rates are low, and while house prices have risen, consumer debt remains manageable. The increase in government borrowing over this fiscal year and next will dampen prospects for the bond market due to increased issuance.
Risks have slightly increased on the growth front. The government's forecasts for economic growth are 1.6% this year rising to 2.5%-3.0% next year and 3.0%-3.5% thereafter. We believe that a stronger global background will be required to help to achieve these levels of growth.
The case for an interest rate cut in the UK remains limited due to the strength of the housing market and consumer credit. More stimulative policies in Europe and US will assist.
Equity markets in the UK and Europe will be heavily influenced by the US market. In the near term we expect some reversal of the recent gains to occur and to provide a firmer base for a more sustained upward move in 2003.
Consumer confidence held up well in the UK over the course of 2002
The UK economy remains one of the fastest growing and has been robust in the face of a major economic slowdown
The case for an interest rate cut remains limited in the UK due to housing market strength
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