Strategy: Improved optimism may take time to come through
Spicers quarterly strategy paper looks at US growth prospects and the identification of sectors which have historically done well in the economic conditions we are now experiencing.
Wednesday, July 25th 2001, 5:30PM
US economic growth should recover to long-term trend rates by early 2002. However, the rebound in corporate profits may lag the overall economic recovery.
US equity markets have enjoyed a powerful rally since lows in early April. There are two ways to interpret this improved performance — as the resumption of the great bull market, or as a "bear market rally" (a brief resurgence) before negative long-term trends reassert themselves. Equity bull markets historically resume when growth in the economy and corporate profits are at a low point.
With regard to the economy, we forecast that rising unemployment and corporate layoffs will dampen consumer spending, however weakness in consumption will be partially offset by a revival in capital spending. Lower interest rates and federal income tax cuts will provide further fuel for a return to trend growth as we enter 2002.
Despite this relatively optimistic view of the economy, it may be a challenge for company profits to make a strong recovery in the short term. The rebound in earnings growth could lag the economic recovery over the next year. Furthermore, valuations are not as attractive as they were at the end of March.
On balance, we think the equity markets will continue to move ahead, but at a more moderate pace. Skill in stock selection will be of paramount importance, particularly in the technology sector. Falling short-term interest rates will induce investors to shift out of cash instruments into equities in this year’s second half.
Energy, materials, cyclicals, and financials, semi-conductors, computer services, and software are sectors, which traditionally do well in an environment of rebounding economic growth with low corporate profits.
The economic conditions such as we are experiencing at present have historically been modestly supportive to the above sectors. But in today’s environment, stock-specific fundamentals, particularly those that point to an ability to generate and sustain earnings growth, take on an even greater significance than usual relative to economy-wide top-down factors.
What’s different in this cycle is that capital spending, not consumption, has led the slowdown; thus certain sectors that often lead a recovery, such as US autos, construction, and food, are not expected to lead in this cycle. Some consumer areas, however, are expected to perform well in this environment, including beverages, restaurants, tobacco, footwear, toys, lodging, and specialty retail.
Several other observations are worth making. Pharmaceuticals are considered defensive holdings, but the current environment of low-profits and rebounding economic growth has historically been favourable for these stocks.
Finally, it is important to note that technology has traditionally neither led nor lagged the market in the environment we are forecasting. Within technology, telecom equipment stocks have historically performed well, but we are not yet positive on this sector given the overcapacity generated during the boom of the late 1990s.
Sector Outlook
By our measures, equity markets worldwide are now very close to fairly valued. During the past 12 months, investors have been rewarded for finding stocks that were cheap.
US equities - We remain optimistic with respect to the US equity market, anticipating that small-cap stocks will have an advantage this year relative to large caps.
Non-US equities – Most European equities are still less attractive than in other regions. The exception is France which now sports attractive valuations. UK stocks look promising due to easier monetary policy from the Bank of England, and low inflation. The prospects for emerging equity markets are also improving.
Australasian equities - We contend that valuations remain attractive on either side of the Tasman and expect both economies to enjoy a period of sustained growth which should produce sound equity market performance.
Australasian property - The Australian industrial property sector retains a high yields, low growth profile. The outlook for the Australian office sector has become less compelling and retail mall growth is likely to remain static for some time. Within New Zealand the prerequisites for sustained capital growth from property remain absent. Infrastructure assets continue to be favoured because of the more significant barriers to entry.
US fixed income - We remain neutral on US Treasury bonds. Mortgage-backed securities continue to offer attractive value even after outperforming over the past few months. Corporates are fairly valued and we remain neutral in this sector. Credit risks have diminished as a result of the Federal Reserve’s rapid easing of interest rates.
Non-US fixed income - Our currently favourable view of European bonds is highly dependent on continued stability in the euro. While the weakening of Japan’s economy is a positive for the bond market there, our outlook remains negative. We are pessimistic on emerging-markets bonds over the next few months.
Australasian fixed income - The equilibrium levels for local bond yields are somewhat higher then would normally be the case when the US economy slows. If the recent rise in long-term bond yields continues, our valuation models will begin to show Australasian bonds as favourably priced.
Equity market assessment
Global economic recovery now seems more likely in late 2001 and early 2002. But this improved economic optimism may not immediately translate into broad equity market performance. Equity valuations are much less compelling than in March but a selective approach to stocks should reduce portfolio risks associated with further market volatility. Currency volatility may continue to rise and New Zealand-based investors should protect themselves where possible against unfavorable exchange rate movements.
Aaron Hing is the head of financial advice at Spicers.
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