By James Abate, a US fund manager at GAM The downturn to the economy following the 11 September ...
By James Abate, a US fund manager at GAM
The downturn to the economy following the 11 September tragedies was far shallower than we expected, particularly in terms of consumer demand.
Initially we believed that the economy had compressed an eighteen-month soft landing into a short-term sharp recession. We felt the fourth quarter of 2001 would be the bottom of the valley and investors would look beyond it in determining intrinsic values for equities. Our enthusiasm for the market was tempered due to high valuation levels in key index sectors such as technology, financials and health care. However, old economy stocks in the basic materials and capital goods sectors offered good opportunities.
It is now apparent that both the economic downturn was shallower than we expected, and that the recovery or normalisation has occurred much more quickly. The most recent industrial production and inventory numbers are robust, which suggest that the overall economy is expanding.
Whereas stock markets reached technical oversold levels only seen last in the dire economic situation of late 1974, the economy did not experience a similar level of contraction, particularly in the consumer segment. With greater analysis, our view is that the classic stock market cycle, whereby definitive sector rotational behaviour in the stock market precedes a strong economic recovery, fails to hold true as a comparison for today, unlike all other late recession/early market recovery periods over the past thirty years. Furthermore, bonds have not rallied alongside stocks, inconsistent with all other market bottoms over the past three decades. We now see this as a market driven by individual stock opportunities.
One positive factor is the remarkable depth and pre-emptive actions taken by the Federal Reserve, which has all but eliminated the normal contraction in consumer discretionary spend- ing as well as the typical stock market recovery induced by a bond market rally. However, the lack of contraction in the fourth quarter may in fact result in lesser growth for 2002.
Despite favourable readings for our short-term equity risk premium we, like many, are still assessing the impact from Enron and other negative influences on systematic risk. During the past thirty years, there has been no precedent for our current situation in which a financial crisis has emerged and already the Federal Reserve's easing capability is largely exhausted and valuations remain high despite the bear market being in its second year.
At the very least, we expect the Enron debacle and other crises to erode investor confidence with a medium-term impact. Given this, volume, fund flows and other trading activity indicators are likely to decrease further over the next few months.
In current market conditions, we find the most appropriate strategy is a hybrid approach. In line with our belief that a sustained economic recovery will not be as easy or as quick as originally thought, simply because the deep contraction did not materialise, we have further emphasised the largest-capitalisation stocks to complement our basic materials positions.
Depth of actions of Federal Reserve.
Economic downturn shallow
Capital discipline within companies.
Enron will erode investor confidence.
Fed's easing capacity is largely exhausted
Bonds have rallied alongside stocks.
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