LONDON — Let us first agree that the US recession is worse than previously thought. Second quarter growth figures for the US economy were published at the end of July. Growth in real gross domestic product (GDP) was a very disappointing 1.1 percent. However, the revised GDP figures for previous quarters caused even more of a stir. According to these revisions, GDP was already on a downward path in the first quarter of last year, i.e. before the attacks of Sept.11. Whereas before the revisions there had been no recession in the United States according to the technical definition (GDP growth negative in at least two consecutive quarters), it now transpires that an entirely normal recession was taking place.
Confidence indicators somewhat lower but robust. Both the Purchasing Managers’ Index, which measures the mood within companies, and consumer confidence, which reflects the willingness of households to spend, have fallen in the US recently. However, too much should not be read into these figures. Although the Purchasing Managers’ Index calculated by the Institute for Supply Management (ISM) has fallen sharply from 56.2 to 50.5, this index level still suggests GDP growth of around 3 percent. Consumer confidence (survey by the University of Michigan) also points to a growth in consumption of around 3 percent.
Reading the financial pages leaves one with the feeling that profit news, i.e. earnings estimates and reported earning, is predominantly negative. Such announcements are currently subject to significant uncertainty as it is unclear as to how, for instance, employee stock options or goodwill amortization should be posted. In order to get a round this uncertainty we use corporate earnings as they are shown in national accounting.
Corporate earnings improved back in the first quarter, and we expect this recovery to continue. Why? Significant productivity gains mean that unit labor costs are falling sharply. Since wages are companies’ biggest cost component, earnings are expected to recover further.
Stock market valuation still low. The price/earnings (P/E) ratio on the world equity market has risen from 15.5 to 17 in the last month. Stock markets have seen sharp growth over the last month while earning estimates have been revised downward slightly. This means that the risk premium has declined. Are the equity markets already too expensive and should we reduce the share of equities in our investments?
The answer is: definitely not. The risk premium for the S&P 500 is still at an extremely high level. In fact the risk premium is currently almost three standard deviations above the historical average. Even if profit estimates were 10 percent too high because stock options granted to employees did not previously have to be posted as expenses, the risk premium would still be more than one standard deviation above the average.
Market sentiment remains bearish. According to the survey of US private investors carried out by Barron’s, the number of bearish responses outweighs the number of bullish ones by around 6 percentage points. The diffusion index of bulls minus bears has rarely stagnated at such a low level. Therefore more money can be expected to flow back into the stock markets in the future. Technical indicators also point to stocks outperforming in the coming months. For instance, the Advance-Decline indicator, which subtracts the number of falling shares form the number of rising ones, shows a turnaround.
Clariden Bank’s asset allocation strategy continues to overweight equities due to the low valuation and the prospect of increasing profits. Technical and sentiment indicators and the somewhat better geopolitical environment also point to an overweighting of equities. And although the macroeconomic environment has deteriorated slightly it still favors equities outperforming bonds.
In our bond investment we are maintaining our short duration bet. Although key interest rates will probably be increased later than previously expected (not until next year), and we do not expect an increase in inflation in the near future, we nonetheless anticipate rising bonds yields. Why? Because bonds yields are currently at an all-time low. We expect investors’ appetite for risk to revive and thus see them moving funds, which they had previously shifted from the equity markets to the bond markets, back into the equity markets.
(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)
— 21 October 2002
