January 2001: Economic commentary on global equity markets

The year 2000 ended up being the worst year for equity markets since 1990 when the Gulf Crisis took its toll on equity markets. Unlike that single event that put markets in a downward spiral, 2000 was more of a steady decline. The United States was in the middle of the storm, sparked initially by concerns relating to economic imbalances and more recently by the deteriorating outlook for corporate profits and the overvaluation in “new economy” shares.

It is often said that when the United States sneezes, the rest of the world catches a cold. The strong US economy has proved to be a double edged sword for the rest of the world in that it has ensured a ready market for the world’s exports while on the other hand it has created headaches for the likes of the European Central Bank, because the longer the boom in the US continued, the more global investors wanted to invest there rather than in their own economies or in the other economies. Money poured into America and the dollar soared. This resulted in other parts of the world being starved of much-needed inward investment. The strong dollar resulted in Europe experiencing problems with rising import prices. This in turn put further upward pressure on interest rates. A weaker US economy may result in a drop in imports from the rest of the world, but on the other hand it means that places like Europe will enjoy greater investment inflows and a lower level of inflation and interest rates. One house view is that the US equity market is unlikely to impress for some time to come – firstly because valuations in certain sectors are still fairly high. Secondly surplus capacity as a result of the investment boom of recent years is likely to keep a lid on corporate profits. Finally, with the current account being rather large, the level of US economic growth must remain below that of its trading partners.

The US Federal Reserve cut interest rates by one percentage point in January to bring interest rates down to 5,5%. Many investors believe that further interest rate cuts will be required in the near future in order to sustain economic growth in the light of the weakening manufacturing sector and disappointing retail sales. Another source stated that corporate profits continued to grow during the second half of 2000 – but not as fast as previously expected by analysts. There is always a lag between interest rate cuts and its impact on the economy. The US stock market is likely to remain uncertain until the outlook for the economy and companies’ profits have become clearer. Another house view believes that the American economy will have a soft landing, primarily due to the fact that the Federal Reserve started cutting interest rates quickly and that they are likely to continue to do so in the short term. The unit cost of labour is falling, which is a sign of efficiency and there appear to be no inherent structural problems. Potential tax rate cuts are likely to spur on consumer confidence together with the potential increase in government spending.

There appears to be consensus regarding the outlook for Europe. Stock market volatility has persisted in Europe – TMT stocks have been affected by swings in sentiment and earnings results and forecasts in the US have influenced investors and their confidence levels significantly. Although the short-term outlook for Europe remains uncertain, over the medium term the outlook is more positive for European equities. Merger and acquisition activity is expected to remain brisk and the economic background in Europe remains more favourable than in the US – this is despite the indications that Europe’s expansion may have peaked. The recent strength shown by the Euro may reduce the competitiveness of the export sector, but lower oil prices should prove positive for both growth and inflation. Another school of thought is that with the Euro finally stabilising after months of poor performance, European equities should perform well.

Fidelity’s view on the United Kingdom is as follows – “UK equities have not escaped the unsettled conditions seen elsewhere. The UK market is likely to continue to be influenced by events in the US, particularly by investor sentiment towards technology and technology related stocks. Interest rates in the UK have been kept on hold for almost a year, but rate cuts in the US and signs of a slowdown at home have led to widespread expectations that the Bank of England will reduce base rates in the near future. Inflation remains below the central bank’s target. A cut in rates would most likely be positive for the stock market and corporate bonds. We believe that the outlook for smaller and medium – sized companies remains attractive and the overall environment for stock-picking has improved.”

In Asia stock markets are prone to sharp swings – political instability in some countries also has a dampening affect on investor sentiment. The economies of South East Asia are still expanding – private consumption is taking over from export growth as the key driver of economic expansion. Some are of the opinion that Asian companies appear to be attractively valued overall – there is a need, however, for business to issue new equity to strengthen their finances.

Investor sentiment in Japan is fragile and is likely to remain so in the short term. In the long term, sustainable economic growth depends on the recovery of consumer confidence and on continued corporate restructuring to make companies more efficient and profitable. One school of thought is that, should the US market continue to be volatile, the same may be expected from Japanese equities. The opposing camp’s view is that over the past 8 years Japanese consumers have been reluctant to part with their hard-earned cash, because of their concerns about rising unemployment and being discouraged by falling prices in the shops. They are of the opinion that the first phase of corporate restructuring appears to have been completed and unemployment has stabilised accordingly. The weaker yen will reintroduce an element of positive inflation to the shops thereby possibly breaking the logjam in consumer spending. In the US and Europe, consumer confidence started to pick up about two years into the recovery. This is where Japan is today. While there seems to be an indication of some signs of recovery, severe problems still exist and a sustainable bull market in shares is not possible until these problems are resolved. Valuation levels are not high, but no immediate recovery is anticipated. There are definitely 2 camps when it comes to Japan. There is without a doubt enormous potential growth in Japan, but as stated above there are serious problems and we recommend viewing it as a high – risk investment.

One view concerning South Africa is that the economic recovery remains on track – growth this year is expected to match last year’s estimated growth of around 3%. Likely tax relief possible in this year’s budget, the lagged impact of lower interest rates and the weaker rand should underpin domestic growth. There is currently a reasonable chance of rate cuts later this year. The weak rand is likely to provide the biggest support for the domestic economy because it offers enormous benefit to exporters, local companies competing with imports and the tourism industry. A weaker rand does, on the other hand, carry risks of higher inflation. The dominant view is currently that the South African Reserve Bank should reach its CPIX inflation target of 3%-6% by 2002. However, the economic recovery remains vulnerable to both external and internal shocks that can trigger off balance of payments problems, resulting in the rand being pushed over the edge – this would naturally increase the risk of interest rate hikes. Recent events have again confirmed that the balance of payments is the backbone of the South African economy and remains vulnerable. This situation is likely to continue until such time as South Africa succeeds in renewing local and foreign investor confidence in its future and in its economy. Although prospects for the year do not look marvellous because of uncertainties and possible risks, the large-scale pessimism towards South Africa should recover over the course of the year, if global economic and financial events remain on track. Other views are that a reversal of petrol price hikes, together with the easing of interest rate fears, should spark a recovery in consumer confidence and thereby reinforcing the recovery in domestic demand. Their view is for a GDP growth rate of around 3,2% for the year. This view is based on the assumption that the rand stabilises against the US dollar and that oil prices remain “in check”. However, the recent Rand weakness – if sustained – could threaten this scenario.

The two key drivers for equity markets are interest rates and corporate profitability. When both of these move in the right direction (i.e. falling interest rates and rising corporate profits) equity markets have the perfect scenario. However, if one is positive and the other negative, equity markets can still make good returns but with less certainty due to market volatility. The year 2000 saw corporate profits failing to meet expectations and rising interest rates. Interest rates are now in decline in the USA and companies are likely to project more realistic profit targets for the year ahead. Expectations are high that both the UK and Europe are likely to reduce their interest rates in the short to medium term. The prevailing view is that the USA will not slump into recession – but if it does then the outlook for all markets will be negatively affected.

Finally, from an in-house point of view, we are of the opinion that it is unwise for clients to attempt to time the markets. For market timers, the fact that the best and worst days often come close together only adds to the chances of getting it wrong – often with serious consequences. We believe that investors can minimise the risks associated with timing by remaining fully invested in solid fund management companies who have the expertise and resources to meet these challenges.

This report is based on information sourced from various institutions, both local and international. The report reflects a variety of views and is not intended to convey investment advice. Please consult us to obtain specific advice relevant to your investment portfolio.