The gap between strong leading indicators and weak stock markets has widened since the beginning of the year. The Purchasing Managers’ Index in the USA for example reached a level that would be compatible with economic growth of between 3.5% and 4.5%. Around the turn of the year, the Purchasing Managers’ Index was pointing to growth of approximately zero. Despite this clear acceleration of economic indicators, the world market has lost almost 10% of its value since the beginning of the year. This kind of discrepancy between the development of the economy and that of stock markets is highly unusual.
Warren Buffet recently pointed out that an improved economic environment does not automatically result in rising share prices. Between 1964 and 1981 for example the US economy considerably increased production but the Dow Jones hardly rose at all. However charts have shown that the equity market and the economy have, with a few exceptions, run parallel over the last 30 years.
The first and second discrepancies between stock market performance and the economy were caused by the oil price crises in the early and late seventies. This triggered a substantial rise in inflation and in interest rates, prompting an immediate slump on the equity markets, although the leading indicators continued to point to economic expansion.
The last case of a stock market slump despite good leading indicators was the stock market crash of 1987. In the period preceding the stock market crash in October 1987, the price-earnings expansion rose from 9 (at the beginning of 1985) to 14 (September 1987). From the beginning of 1987, this price-earnings increase went hand in hand with a rise in inflation and interest rates, with the result that the risk premium (defined as the ratio of the earnings yield to the 10-year bond yield) reached an alarming low. As a matter of fact the low risk premium was already sending out warning signals before the slump in share prices in the spring of 2000. Another cause of the 1987 crash was the so-called “twin deficits”. In 1987, the current account deficit was 3.5% of gross domestic product and the budget deficit was over 4% of GDP.
Unlike the three stock market slowdowns mentioned above, the current slowdown cannot be explained in terms of fundamental macroeconomic data. An oil shock is highly unlikely. Inflation rates remain very low and there are no signs of a sudden and massive increase in interest rates. The P/E ratio has fallen in recent months and risk premiums — in contrast to the situation in the summer of 1987 and in January 2000 — are not at a record low but are in fact quite high. Apart from this, the US budget, which has suffered as a result of expansive fiscal policies last year and this year is absolutely solid, with a predicted deficit of 1.2% of GDP in the current year. The only parallel to the 1987 crash is the high current account deficit currently standing at 3.9% of GDP.
The current stock market slowdown can only be explained by a loss of confidence in accounting practices and in company management in general, prompted by various scandals (Enron, ABB, Tyco, El Paso, Swissair).
Even though company reports on quarterly profits and quarterly sales are not yet all that encouraging, we are convinced that the profit situation will improve considerably over the next quarters. This conviction, which we have held for some time, has now for the first time been confirmed. Corporate profits rose by 3.7% in the first quarter of this year. Corporate profits will increase not only as a result of unit wage costs — which even decreased in the last quarter — but also in response to higher demand.
It is not only in the USA that leading indicators point to a lasting economic upturn. Japan achieved phenomenal economic growth of 5.7% in the first quarter (on an annualized basis) and in this respect is head to head with the USA. This economic growth is based above all on high exports and consumption, although company investment continues to decline. Incoming orders and the leading indicator are both pointing upward, which means that we can expect a sustained economic upturn.
In Europe economic growth in the first quarter was disappointing, but incoming orders as well as company survey results show that the economic upturn in Europe will follow that in the USA with the customary time lag of one to two quarters.
In view of the favorable economic environment, which points to a marked improvement in company profits, we will maintain our overweighting of equities over bonds for our investment objectives Conservative, Balanced and Growth. Another argument for overweighting equities is that we anticipate interest rate rises by the US and European central banks between September and December of the current year.
As long-term bonds tend to be hit harder during interest-rate hikes than short-term bonds, we are leaving the duration in our bond portfolio below the corresponding benchmark duration.
The sectoral performance in the past months has not followed a specific pattern. Cyclical and defensive sectors (materials and consumer staples) have improved noticeably since the start of the year, although the world market index dropped by almost 10%. Apart from the telecom and IT sectors, which have lost about 30% since the start of the year, the defensive health care sector ranks third on the list of losers. These variations in performance progress do not entitle us to assume that market participants have abandoned their hopes of economic recovery — otherwise defensive sectors should have had higher price gains than cyclical sectors.
Clariden Banks investment strategy remains virtually unchanged, as the global economic recovery remains in sync. We changed our sector strategy in mid-April, when we reduced the energy sector from overweighted to neutral. The materials, industrials and heath care sectors remain overweighted. Consumer staples and telecommunication services remain underweighted. The materials and industrials sectors are cyclical and should benefit from the upturn. We continue to expect further upward revisions of earnings estimates. Health care is one of the defensive sectors but with its underperformance in recent months, its P/E of 20.2 is historically favorable. The PEG ratio is even more than one standard deviation lower than the historic average.
(This article is contributed by Clariden Bank, London, which is a wholly-owned subsidiary of Credit Suisse, Zurich, specializing in asset and client relationships management.)