LONDON, 2 June 2003 — Since 1999 share prices and government bond yields have been moving in step. If economic prospects have deteriorated, share prices have fallen as profit expectation dip. Bond yields have also fallen because an economic downturn leads to expectations of lower inflation. If on the other hand the prospects of economic recovery have perked up, both share prices and bond yields have risen. Recently, however, this automatic link has been severed. Share prices and bond yields matched each other from the beginning of March to the end of April but since the start of May share prices have been picking up while bond yields have fallen to new lows. Are the equity markets expecting a different economic scenario than the bond markets? Is the equity market excessively euphoric about an economic upturn and can we expect a drastic correction on the equity markets?
We believe that there is no necessary contradiction between the recent simultaneous recovery of equity market and bond market prices. The steep drop in the oil price means not only that economic prospects improve but that inflation is also falling. Annual inflation for consumer prices fell steeply in the US from 3 percent in March to 2.2 percent in April. Lower oil prices cut company energy bills and raise their profits. On the other hand, lower oil prices mean a reduction in inflation and consumer purchasing power (real disposable income) rises. So the recent slump in yields is not in our view a sign of another economic slump. The latest set of economic figures does not point to a downturn either.
The US economic data that have been released recently present a mixed picture. The University of Michigan consumer confidence index climbed again in May but the business climate in manufacturing has not yet started on a positive trend after the end of the Iraq war. The consumer confidence index points to growth in private consumption of the order of 4 percent. In contrast the manufacturing purchasing managers’ index suggests GDP growth of less than 2 per cent.
Official economic statistics present a picture that is just as mixed as survey-based economic figures. Industrial production in manufacturing industry fell for the third month running and the annual growth rate is therefore negative but there are hopeful signs on the horizon. IT production has climbed steadily over the past four months. The annual growth rate of the high tech branch is over 9 percent.
After the seven week rally, the equity markets now seem to be entering a consolidation phase. The recently published economic data present a mixed picture. We are therefore leaving the weighting of equities and bonds neutral, as in the previous month. Another reason for restraint vis-a-vis equities is that disproportionately large numbers of private investors in the US are becoming bullish about equities. We continue to regard equity markets as attractively valued and we anticipate an economic recovery in the medium term. The following developments would prompt us to increase our equity commitment: 1. better macro-economic data; 2. companies announcing positive company and industry prospects; 3. the overbought technical indicators have been significantly reduced.
In our equity strategy we are upping the financial sector from underweight to neutral. With a P/E of 12x, the financial sector is more favorably valued than all nine other MSCI sectors. In historical terms, P/E and relative P/E in the financial sector are low. At the same time as increasing out financial sector exposure, we are demoting the industrial sector from neutral to underweight. The industrial sector — and especially the capital gods sector is still suffering from low capacity in the US economy that is depressing demand for capital goods. On top of this, the industrial sector is late cyclical in nature.
Our bond strategy of keeping bond duration lower than the benchmark did not pay off last month because yields for ten-year bonds hit new historical lows. We expect that the fall in inflation is a one-off event triggered by the lower oil price. We therefore do not expect a further fall in inflation and yields. On the contrary, we anticipate a rise in yields. The medium-term economic upturn that we anticipate should mean that the record low real yields will increase and tend towards the historical average. In contrast to the US, we expect to see a further interest rate reduction in Europe, so for new investments in euro we recommend the selection of duration that is half a year higher. Our recommendation to investing high yield bonds paid off. We stick to this recommendation.
(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)
