As rate cuts slow, bond markets are nervous while the equity markets may fall as they adjust to lower earnings
GAM Diversity has made small but consistent gains throughout the year to date and is up nearly 4%. We remain cautiously positioned as we see a difficult time ahead. We think equity markets will fall as they adjust to lower earnings while bond markets are nervous as they start seeing an end to the aggressive rate cuts.
Despite the equity market falls year to date, the multiples that each of the major markets continue to trade on, are at the high end of the normal ranges. The corrections have been dramatic in the tech sector, as highlighted by the over 60% correction in the Nasdaq from its peak.
Part of the explanation for the limited fall in equities must be attributed to the swift intervention of the Fed. But the steepening of the yield curve suggests the bond market expected a strong recovery and was concerned for inflation which offset some of the positive impact of the short-term rate cuts.
Another reason why markets have not fallen dramatically is that to date there has not been a notable withdrawal of capital by mutual/retail fund investors.
But will the interest rate cut medicine work on the economic slowdown? And if so, when? This is where the economic data and the trading comments from corporations become 'fuzzy' and often contradictory. We have seen the NAPM Index suggesting a notable rise in new orders outside the tech sector, implying a possible V-shaped recovery, while we hear that US corporations are reporting further falls in orders. This suggests there is little likelihood of any V-shaped recovery.
We do not think further cuts are the saviour of the markets. For how much longer will the US consumer keep spending as job losses and the negative wealth effects start to take hold?
Compare the actions of the Fed to those of the ECB over the last six months. Admittedly, the data for the ECB has been signalling inflationary pressures that have been missing in the US, making cuts in Europe a more difficult option. The clouds of gloom have been gathering, particularly in Germany which is falling into a possible recession, with industrial production and business confidence falling rapidly.
The main cause of inflation seems to be energy and labour costs and food prices (following the outbreak of foot and mouth disease). There are tentative signs these are now stabilising which should help data, giving the ECB the confidence to make more aggressive rate cuts.
European hedge managers have been faced with sharp sector rotations and short covering rallies followed by further lurches down in the market with seemingly little or no discrimination for good or bad companies.
Prime minister Koizumi is being increasingly questioned by the investment community who, after reviewing his various reform proposals, does not think they are as radical as was initially suggested. Due to his domestic popularity, Koizumi may be able to push through some reforms in the banking and retail sectors, but their long-term impact is questionable .
To date, the trade surplus may have been the only real counterweight to capital outflows from Japan, and if there is reform and trade liberalisation, implications for the yen are negative.
The Government has downgraded its economic assessment for the fourth consecutive month. Japan remains highly vulnerable to the global slowdown with little sign of domestic stimuli affecting the market. Slowing exports have taken their toll on growth. Koizumi's prescription for the ailing economy avoids the traditional 'capital injection' approach and emphasises a structural reform approach. Although not yet explicit, the implication is for the need for things to get worse before they can get better.
We remain unconvinced about Japan. Opportunities will be available, but we suspect it is still too early. Many commentators have spoken about the great long-term investment opportunities in Japan. We do not doubt that some exist, but think they will get cheaper.
Pacific and emerging markets
The loosening of monetary policy in the US had its typical short-term positive effect in the region with Hong Kong cutting rates. Unfortunately, the evidence of a regional slowdown continued ' the main causes being the dramatic fall in external demand and continued weakness in the domestic consumption. Hong Kong suffered from a fall off in Chinese-led exporters. We believe the continued re-adjustment to the global slowdown means the outlook is poor for the short term. Emerging markets have these concerns while having specific problems with Argentina and Turkey. It is our experience that such problems have a habit of having a contagion effect. We will maintain low weightings to both of these regions and where possible switch to less directional/market neutral strategies.
Despite the gloom, the possibility of a period of modest global growth appears likely. This will be driven by the US economy, but it will be at a far lower level as the economy readjusts to its norm and the excesses of recent years work themselves out.
As markets fall, it is important not to become too negative. The transmission mechanism of monetary policy typically takes nine months to take effect, so we may see the start of a recovery in late 2002/2003. It is vital to participate in the first few months of a new bull market. If not, your long-term returns for equity investments are often equal at best to the other asset class.
We will remain cautiously positioned while being careful to maintain the option of quickly expanding our exposure to direction-driven hedge strategies. The non-correlated element of diversity remains at 40%. This is made up of Commodity Trading Advisers, discretionary, Macro Managers, relative value and systematic strategies. The balance is in a variety of other strategies including event driven, arbitrage, market neutral and equity long/short. The equity long shorts constitute 40% ' 45% of the fund.
We will continue with the bias towards equity long/short managers who have a low correlation/defensive stance for the time being. An overriding factor for us however is that we are cognisant of the possibility of liquidity/sentiment-driven rallies. For this reason, it is perilous to be aggressively short the market and chase negative momentum indiscriminately.
To promote 'long-term investment'
Switching 'hard and expensive'
Smaller funds still packing a punch
To drive progress