LONDON, 14 October — The decline in global equity markets accelerated in the third quarter. The magnitude of the slide took all market participants by surprise, given that prices had already fallen by 20 percent in the first six months of the year. Our overweighting of equities has therefore not paid off for the moment. Why did equity markets perform so badly compared to bonds?
— The economic recovery that we predicted is progressing, but at a slower pace than many market participants hoped. The equity markets tend to ignore positive signals while latching gleefully on any sign of economic weakness.
— Fears of deflation, which would be anathema for the equity markets, have increased considerably, even though hardly any indicators point in this direction. In fact it can be assumed that inflation will be low over the coming months.
— Institutional investors — insurances in particular — have been forced to sell huge numbers of shares because their capital coverage had dwindled as a result of equity market losses. Most insurances now hold only a small percentage of equities in their portfolios.
— The threat of war in Iraq is looming larger. Uncertainty about the possible extent of such a war further depressed investor confidence and has led to large discounts on share valuations.
— These factors have triggered a flight into money markets, alternative investments, real estate and bonds. At the moment markets are influenced less by fundamentals but most of all by negative hype.
We realize that our overweighting of equities will not win us many friends at the moment. However, our main concern is to maintain an investment style that is rigorous and disciplined in its concept and geared to long term profitability. We are convinced that this approach is correct and experience has shown that in the long term this strategy has proved right. To take account of the uncertain investment environment and to limit risks, we have decided to diversify into alternative investments. It would undoubtedly be easier for us to capitulate, to change course and to go with the market flow. But this would mean abandoning our investment principles. In brief, these are:
— Risk-adjusted real returns determine where investable assets go in the long term.
— In the long term, the markets will be mainly influenced by fundamental factors, not by mood swings.
— We believe that the greatest achievement of financial market theory, the “mean reversion” theory (which states that random variables tend to return over time to a long-run average) will remain valid in future.
Some observers of the business cycle assume that following the recession of 2001 the world economy is facing another recession (“double dip”). A double dip has also been factored into share and bond prices. Even though economic indicators have weakened considerably compared to the first half-year, the majority of indicators still point to economic recovery, though at a slower pace. We will now examine some of these indicators more closely.
The US Purchasing Managers’ Index remained at 50.5 points in August, indicating economic growth of around 3 percent. The University of Michigan’s consumer confidence levels fell back again in September from 87.6 to 86.2, signaling growth in private consumption of around 2 percent. However, consumer spending was very high, rising in July by 0.8 percent and retail sales figures for August show no signs of private spending weakening either. In fact, retail sales rose by 0.8 percent which means they are 5.2 percent higher than a year ago.
There was enormous relief when new orders for July rose by 4.7 percent in the US after falling 2.5 percent in June. On a year on year basis, new orders were up 2.2 percent which is the first time since the end of 2000 that they have not been flat. However, the joy was short-lived as, according to the Institute for Supply Management’s (ISM) August survey, manufacturers are much less optimistic about their order backlogs than in the first half of the year. Companies were obviously far too euphoric in the first six months, whereas now they are expecting new orders to stay at their current levels overall.
Business confidence in Europe has become decidedly gloomy, as can be seen, for example, by the so-called Ifo economic clock which is currently moving anti-clockwise. Business expectations in particular have deteriorated so badly that the hands on the ifo economic clock have swung away from the upturn section back into the recession one. The business climate for the euro zone calculated by the European Economic Research Center (ZEW) has also significantly deteriorated in the past two months. But like the Purchasing Managers’ Index in the US, the ZEW index indicated extremely optimistic sentiment in the first half of the year. The index’s current stance of 43 still signals growth in industrial production of 2 percent, whereas the index stance in the second quarter still suggested growth of around 5 percent.
The business climate in Japan has markedly improved over the past few months, with demand for its exports boosted by the economies of its Asian trading partners to whom Japan sells around one third of all its exports. Even consumer sentiment has risen steadily in the past few months, but deflation still persists. So it is not surprising that private consumption is only rising modestly, given that consumers expect to buy goods cheaper tomorrow than today.
We are sticking to our policy of overweighting equities despite the difficult economic environment. Firstly, we are assuming that the US and the world economy are not facing another recession. However, if a double dip occurred, profit estimates would have to be revised downward and shares would be less profitable than bonds in the coming months. Secondly, equities are undervalued and hence cheap at the moment. The P/E ratio is not high, while the risk premium for shares is at a record level.
Other valuation indicators such as the implicit earnings growth rate and the price/book ratio confirm us in our view that the valuation of the equity markets is extremely favorable. The Mean Reversion models do not help us to determine the precise moment of a turnaround in price movements. Nevertheless over a longer time frame they do enable us to form realistic earnings expectations
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information)