LONDON, 27 May — Equity markets have been down since its high on March 19, the MSCI World index has lost more than 5 percent. The TMT-sector (technology/media/telecom) in particular was weak: IT and telecom services sectors were down by around 16 percent and the media industry group by around 13 percent. In the cyclical sectors, materials performed quite well whereas industrials and consumer discretionary disappointed.
The defensive sectors generally outperformed (consumer staples and utilities), whereas the health care sector also disappointed investors. The question persists to be: Is bad economic news behind these disappointing developments of the world index? Or have equities lost value even though the economic environment has improved? If the latter interpretation is correct, the low equity prices should be a good opportunity for new equity investments.
If we look on recent economic releases, we conclude that most business cycle indicators point upward. We emphasize that both US manufacturing and US non manufacturing purchasing indicators came in above the important 50-point level in April. The slight reduction of both indices and the fact that the releases were below economists’ expectations does not bother us, as index levels still indicate a future economic growth rate of around 4 percent.
In the United States, the very high productivity growth of 8.6 percent for the first quarter is especially good news for equities. Since the fourth quarter of 2000, equities have suffered form the worst profit recession since the second oil crisis in 1980. In the fourth quarter of 2001, profits were nearly a quarter lower than one year earlier. No wonder that equities performed poorly. With record productivity growth, which brought unit labor cast growth down to –5.4 percent, we reckon on a rapid recovery of profits, which should be additionally helped by higher sales volumes.
We are therefore convinced that equities will outperform bonds in the coming months. Consequently we see the disappointing equity market performance as a buying opportunity.
The European Central Bank is hinting that an Interest rate hike is immanent. Recently ECB President Wim Duisenberg has prepared the market for a rate hike. For example he indicated that “…the risks to price stability are now more on the upside than on the downside”. Furthermore the ECB fears that inflation expectations in the markets are increasing: “…it is essential that past upward tenancies in prices … do not become entrenched”.
In its latest monthly bulletin, the standard phrase that excessive M3 growth does not constitute a risk to price stability is not included. Instead the central bankers are concerned that “…the reversal of built-up liquidity is proceeding only slowly.” Even though this changed working points to an increase in the repo rate, which is currently at 3.25 percent, we believe that the ECB will stay on hold until September. There are at least three reasons for this.
1. We will experience low inflation numbers in the coming months owing to strong base effects related to the high inflation of food price in early 2001.
2. The recent euro appreciation will dampen import prices.
3. Economic growth in the first half of this year will come in below potential.
As for Japan, even though the hopes that Prime Minister Koizumi would engage in economic reforms were disappointed, the Japanese equity market has been the best performer among the major equity markets since the beginning of the year.
The price gains on the Japanese markets are due to cyclical factors. Indeed the business conditions in Japan have improved in recent months and will continue to do so in the coming months. For example, the inventory to shipment ratio has fallen considerably during the last three months. Now, the incoming demand has increasingly to be covered by current production and can no longer be satisfied by inventories built up earlier. In the past a low inventory to sales ratio has always been a reliable predictor for an increase in industrial production.
For the time being the recovery signs are from export demand only. For example, foreign machinery orders have increased for three consecutive months. But there are some tentative signs that domestic demand is also going to improve. There has been a slight increase in consumer confidence in the last two months, so we believe private consumption will accelerate. The business sector, which has been on an investment strike during the last three years, is also in a better mood. The medium and small enterprise conditions index has improved, which may also be due to decelerating unit labor costs. So we are confident that the Japanese recession is near its end.
Finally, in the pacific ex-Japan region, there are some really encouraging signs that the recovery is well established. This is also the most important source of the recovery of Japanese foreign demand mentioned above, as more than 40 percent of Japanese exports go to the Pacific region. It is worth noting that leading indicators of Korea and Australia are definitely pointing upward reflecting a positive trend. There has also been a significant acceleration in Pacific countries’ exports since the beginning of the year.
(This article is contributed by Clariden Bank, London, which is a wholly-owned subsidiary of Credit Suisse, Zurich, specializing in asset and client relationship management.)
