"When winter comes, can spring be far behind?" As I write this on a cold winter's afternoon, Shel...
"When winter comes, can spring be far behind?" As I write this on a cold winter's afternoon, Shelley's question sums up investor sentiment at this time. The poet seems to acknowledge that, on the one hand, the question is only rhetorical: after all, spring will inevitably arrive. Arguably this is the message of the last two months or so in equity markets. But there is also a perception that economic prospects are bleakly wintry and uncertainty over the timing and the strength of recovery could affect equities.
The September attacks on America laid waste more than concrete and lives. In a day, they destroyed the 'peace dividend' of the 1990s. At a stroke, investors were forced to confront a grim duo - war without a clearly defined end against a faceless enemy and a recession in the US, the engine of the global economy. From an investor's perspective, could it really get worse than this?
Frankly, no. Yet history shows us that it does not pay to be a seller during times of war. Contrary to popular belief, war is often a positive factor for investment; opportunities present themselves when it seems that all else is lost. The aftermath of the horrific terrorist attacks is a case in point. Within ten days (and a 15% market fall) of 11 September, world stockmarkets had rallied. "Buy on the sound of cannons" goes the bloodthirsty old adage. Technology may have rendered the cannon obsolete these days (although possibly not for the Northern Alliance), but the sentiment still holds true. Those who invested on the sound of US warplanes are now considerably better off than those who sold at the bottom of the market.
An examination of the fundamentals strongly suggests that economic recovery should materialise in the US during 2002, even if this is delayed until the third or fourth quarter. I am also confident that the global equity rally, which began on 21 September, marks the beginning of a new bull market.
I look at four indicators to draw this conclusion. I consider the first of these to be the leading indicator, namely, the direction of global interest rates (as well as the gradient of the yield curve). As the current phase of corporate cutbacks and destocking draws to a close, the primary risk to an economic recovery is a fall in consumer confidence. Here, though, the aggressive cuts in global base rates seen since the beginning of 2001 and intensified since 11 September have made a considerable difference, and should ensure that consumer spending remains resilient.
Whilst there is little scope for further interest rate reductions, I challenge the consensus in bond markets that has priced in imminent rise in Fed funds. There is an historic precedent not to rush to raise rates: in the early 1990s, Alan Greenspan waited three years after his cuts before he raised the cost of borrowing again. More recently, the example of the Bank of Japan, which raised rates as soon as there was a glimmer of improvement in the economy and thereby effectively managed to abort recovery, provides a warning to other central banks. So, I believe that US Federal Reserve, aided by continuing low inflation, will keep short rates unchanged throughout the whole of 2002.
Secondly, I turn to money supply, which I regard as a coincident market indicator. The measure can be somewhat difficult to track but does fuel financial asset prices and empower or constrain equity markets. In the past few months, monetary aggregates in Europe, the US and Japan have taken a sharp leap upward, helping markets to rally. The only real risk to the current growth of money supply would be a decline in bank lending to corporates: an unlikely scenario given the length of time that companies have had to put their houses in order. My conclusion is that money supply growth is a strongly positive force at present.
Valuations are my third indicator, as a key long-term determinant of the value markets represent. Ultimately, markets price themselves off bonds and on this relative basis, the UK, Continental Europe and the Far East (including Japan) are at 'once in a decade' levels of cheapness, even after the rally to date. The US remains slightly more expensive, but nonetheless represents satisfactory value relative to fixed income investments. So valuations remain supportive too.
But what of the fourth indicator, earnings momentum? Here appearances take a turn for the worse. The past three months have seen substantial declines in earnings momentum, most significantly in Continental Europe. In the UK, earnings momentum was already negative and has become more so. The picture is similarly dark in the US, Japan and the rest of the Far East. Overall, earnings momentum is more negative than at anytime since 1991 - a year that was mired deep in recession. However, it is worth bearing in mind that earnings momentum is a lagging indicator that tells us more about the recent past than the future.
The final tally gives us three positive indicators and one very poor one. This is a typical scenario for the early stages of a bull market, but one which is not without its problems. Our negative earnings momentum indicator highlights the risks to a recovery in 2002: chiefly, continuing pressure on companies and further earnings shocks. This suggests that, whilst markets will recover during 2002, there will nonetheless be a period, most likely the traditionally weak period from early summer to mid autumn, when investors begin to worry over the lack of evidence of an earnings recovery. This could intensify market volatility and lead to temporary nervousness in sectors, like as TMT, where hopes and valuations are highest, or in areas, such as manufacturing, where the impact of recession is most acute. Overall, the balance of the four key indicators - a positive interest rate outlook, improving money supply and attractive valuations - imply that the overall market trend next year will be upwards.
With a recovery on the horizon, investors need make sure they are correctly positioned. The chief challenge will be to identify sectors, and companies within those sectors, where earnings momentum can improve, regardless of whether a stock may carry a 'growth' or 'defensive' label.
In a recovering economy, technology offers strong rewards, although a selective approach is essential to avoid sub-sectors, like semiconductors, that look overvalued. Overcapacity remains a significant problem in the 'new economy' and could take years to unwind. This is likely to be a particular problem for technology hardware manufacturers, especially suppliers to hard pressed telecoms service companies, though more stable areas such as software and software services should do rather better. Additionally, resources could prove rewarding in 2002. Supply in resources, with the notable exception of oil, is much tighter than would usually be the case at this stage of the economic cycle, and this could lead to exaggerated price movements in commodities as the economy picks up.
As far as investment styles are concerned, equity income remains a strong choice in a low inflation environment where nominal earnings growth is lower and consequently dividends account for a higher proportion of total return. As the importance of income increases, we should see a rise in demand for products which can help investors fulfil their income objectives.
So the conclusion suggested by my four equity market indicators is overall a positive one. Spring is not far away, but it will surely arrive, although it may well be delayed into the second half of 2002. This is a comforting thought for investors facing a chilly midwinter.
For financial advisers only - not for onward distribution. No other persons should rely on any information contained within this document. Issued by M&G Financial Services Limited, regulated by the Financial Services Authority. Registered office: M&G House, Victoria Road, Chelmsford, CM1 1FB, registered in England No 923891.
Two global vehicles
'Further plug advice gap'
Must appoint separate CEOs and boards
Advisers do come out well
Will report to Mark Till