After a turbulent 2001 and a difficult end to the year, there are a few signs that global stock markets are on the slow road to recovery
2001 has the dubious distinction of having been one of the most difficult and dramatic periods for global stock markets in a very long time. But after the turmoil of the last few months, there have been some better signs.
Despite experiencing the largest manufacturing recession in the US since the 1930s, US investors have shown themselves to be increasingly inclined to look past the immediate downturn to the prospects for recovery later in 2002.
Progress in the war in Afghanistan has also provided additional reassurance. Even Japan's stock market has held steady despite more bleak news about the economy, boosted by the improvement in the external outlook. The net result of this is that, at the time of writing, most major equity markets are trading above the levels they reached in the weeks prior to the terrorist attacks in New York. So what does 2002 have in store?
Cash rates globally are low and are expected to remain so in order to safeguard economic recovery. The expectation of low and falling inflation suggests they will not be raised for some time, meaning that cash returns will be very limited. At the same time, the current level of bond yields is lower than at the end of 2000 and the likelihood of further capital gains is low.
We anticipate yields rising to a degree throughout 2002 as the economic recovery takes hold, meaning that bonds will provide limited returns. Equities will be well supported by low interest rates and improving economies. They have not had more than two negative years since 1949. Accordingly, we expect equities to be the best performing asset class in 2002.
The latest economic data suggests we could be close to a trough in the US economy. We think the substantial monetary and fiscal easing seen so far will be sufficient to ensure the economy returns to a growth path.
Huge amounts of liquidity, courtesy of the Fed, are finding their way into financial markets. The earnings outlook for equities is also improving, but we do not expect to see a return to the level of earnings growth which characterised the late 1990s. As we have said before, we expect the US economy to lead the global economic recovery in 2002. The US equity market is not particularly cheap and we wait for an improvement in valuation or greater certainty about the medium-term outlook before committing to greater exposure.
Throughout 2001 we have maintained an overweight position in UK equities. The UK market is characterised by large weightings in companies, particularly in the oil, banks and pharmaceutical sectors, which have relatively consistent and reliable earnings streams, an emphasis which helps to make the UK market attractive during periods of heightened uncertainty and general economic slowdown. Whilst question marks remain over the length and depth of the US economic slowdown and the health of the global economy, we expect to maintain this overweight position. However, we are mindful that in the event of a sustained economic upswing, this defensiveness would limit the market's appeal. Once we see more definitive evidence that the US economy has turned the corner, we expect to reduce or remove the overweight exposure.
The European Central Bank's (ECB) decision to cut interest rates by 50 basis points in the aftermath of September's terrorist attacks signalled a decisive change in the fortunes of European equities. After lagging over the summer months, recent performance has been much better. Despite the firmer tone in markets, the economic outlook is far from benign. The latest economic releases suggest the economy is slowing markedly. Euroland GDP grew just 0.1% in the third quarter and Germany is now in recession. Given that pricing pressures are declining and inflation is likely to dip below the ECB's 2% ceiling shortly, we expect the ECB to cut rates again, possibly in February once the initial circulation of the new euro notes and coins has been completed.
However, in itself this is unlikely to lead to a rapid renaissance in European equities. Although Europe will benefit from a recovery in the US economy, if history is any guide, it is likely to lag any pick-up in the US by between three and six months. Overall, the lacklustre earnings outlook causes us to retain a neutral rather than overweight exposure despite the slightly more attractive valuation offered by European equities in comparison to US equities.
Although the Japanese economy and equity market should, in theory, benefit from a global economic recovery, the desperate plight of the economy and the authorities' policy paralysis suggest that it is not appropriate to remove our underweight position for the time being. Despite the gloom, the outlook for the stock market is not necessarily poor. Valuations are cheap relative to bond yields and on a historic basis the market P/E ratio is low, but Japan has been cheap for quite some time and could get cheaper still. While there appears to be little prospect of good news in the short term, if a positive catalyst does emerge, the stock market should be receptive. As a result, we are monitoring developments closely, but prefer to be underweight, seeing better opportunities elsewhere.
Given that the past few weeks have seen a strong rally in Asia, we believe that the regional markets may be in for a period of consolidation. The medium-term outlook is more positive. If the aggressive monetary easing seen so far succeeds in engineering a recovery in the US economy, then Asian and emerging markets will be big beneficiaries. In Latin America, Argentina's ability to avoid default is doubtful given its large debts and pegged currency. However, the potential for contagion across other emerging markets should be limited due to better fiscal discipline, floating exchange rate regimes and stronger banking systems.
With the economic and corporate earnings outlook cloudy, equity market volatility is likely to persist. The key question is: when will the US economy start to recover? While we do not expect the US economy to recover until mid-2002, equities as a forward-looking indicator should move to discount a recovery perhaps as early as the first quarter of 2002. In the short term we expect to maintain a relatively defensive stance. As a result, we continue to put safety first and emphasise companies across a range of sectors which are reasonably valued and have a high degree of earnings visibility.
Paul Bruns and Elaine Parkes
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