The last six months have seen unprecedented volatility in the world's stock markets. Led by strong d...
The last six months have seen unprecedented volatility in the world's stock markets. Led by strong demand for New Economy growth stocks, and in particular TMT stocks, markets reached record highs.
Equally, the subsequent downward correction in technology stocks was as indiscriminate as during the bull phase, with valuations being questioned. Interest rate rises also contributed to this volatility with pre-emptive rises to combat increasing inflationary pressure from monetary authorities around the world.
The short-term outlook for markets is finely poised. Recent economic figures in the US suggest that Alan Greenspan's monetary tightening could at last be beginning to slow the economy. The G7 leading indicator is almost six months past its peak. This has lowered expectations as to how high interest rates will have to rise and bond markets have rallied as a result.
If these weaker economic statistics turn into a consistent pattern throughout the summer, markets may take relief from this and the steadier - and slightly stronger - movements of the last few weeks could persist. However, if evidence that the economy is not slowing returns, we would expect a swift reaction from the authorities to avoid future action clashing with the presidential elections in November.
At this stage in the cycle, we favour equities over bonds over a 12-18 month period, although bonds may produce good returns over three to six months. Historically speaking, in the 18 months following the peak in leading indicators, six out of the last seven peaks produced global equity returns of more than 10%. We are underweight cash due to the increasing probability of falling interest rates.
In the UK, there is also evidence of a slowdown in the growth rate and it seems to be nearer the peak in the interest rate cycle than elsewhere. The UK equity market offers good value following two years of relative underperformance. The economy looks reasonably healthy and inflation remains under control at one of the lowest rates in Europe.
Provided earnings growth expectations can be met and a slowing economy does not lead to the scaling back of these expectations for this year and next, the market may be able to break out of its narrow trading range. Earnings forecasts for the market have been raised, although concerns remain over ongoing margin pressure from weak pricing and higher raw material prices. We have a neutral weighting to the UK.
We continue to favour continental Europe markets where they are behind the US and UK in the economic cycle. The economy continues to benefit from the lagged effects of a weak euro. The prospect of positive earnings surprises and continuing restructuring bode well. Inflationary pressure is above expectations principally due to the oil price, but it is likely to remain subdued in the medium term. Business confidence remains positive, as seen in the new issues market.
The prospect for Japan also looks good in the medium term, with sentiment continuing to improve. The Japanese economy returned to the road of recovery in Q1 with annualised GDP growth recorded at 10%, a positive indicator even if the degree is somewhat exaggerated. The recovery is set to continue and should be driven by corporate restructuring. Corporate results for the second quarter are also expected to be good.
With the economic recovery so finely balanced and deflation still a problem, a move towards tighter monetary policy would be premature, but there is a growing danger that the Bank of Japan will raise rates from what it sees as emergency levels.
This may be poorly received by markets. However, for the moment the Bank of Japan has put the much talked about interest rate hike on hold due to the bankruptcy of Sogo, Japan's largest department store.
Investment flows may be hampered by cross-shareholding unwinding ahead of mark-to-market accounting. In the short term, the market may pause for breath, but longer-term we expect to make reasonable returns.
Although economic growth has provided impetus to the region, we are taking a slightly more cautious position on the Pacific and emerging markets until the picture in the US economy becomes clearer. Asia is in transition from export-led to domestic-led growth and the markets are likely to be volatile through that process. Within the region, we prefer the larger markets of Asia where growth is improving helped by strong demand for electronics and electronic components.
The smaller markets are seeing slow progress in deregulation and political problems persist. The global risks are rising and peripheral markets have for now passed their period of peak outperformance. The high correlation between economic activity and emerging markets highlights the risk of a liquidity squeeze.
Almost every economic release during the past three months in the US has been weak, indicating that the economy is slowing with the exception of the tech sector and inflation, often a trigger for a hard landing, remains benign. These, coupled with the continual absence of a large budget deficit, thrift implosion and wild real estate speculation, point to a successful soft landing.
The pricing environment for most products remains tight and all raw material price increases are currently being absorbed through lower net margins. As the economy slows, earnings will also and it follows that we have seen a pick-up in corporate profit warnings, which should place pressure on valuations.
Ultimately, the direction of world markets will depend on events in the US. We are confident that global growth is slowing, believing that US interest rates are nearing their peak as credit markets have completely priced out any further Fed tightening. If a slowing economy can produce a soft landing rather than a dramatic crunch, this should be positive for the medium term outlook for equities.
In the UK, we are more com
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