High income returns likely to decline

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In this quarter's strategy paper Arcus looks at the volatility of international equity markets and the inflation implications of a period of low interest rates.

Monday, August 12th 2002, 4:11AM

The key themes in this quarter's strategy paper are the volatility of international equity markets and the inflation implications of a period of low interest rates.

Why has volatility increased in international equity markets?
The sideways price action of equity markets during the earlier part of this year ended abruptly in June as increased concerns over accounting scandals overshadowed other encouraging developments.

The sell-off itself prompted further selling from market participants who, just like in late 1999 and early 2000, made trading decisions on the basis of recent price momentum. Just as in a bull market, when there are buyers simply because prices have risen, in recent months there have been sellers simply because prices have fallen.

Eventually, such market pressure exhausts itself and securities end up in the hands on stronger holders who have entered the market and are enticed by attractive fundamental values. We believe that we are starting to see signs of this transition.

Does a period of low interest rates have any inflation implications?
For a long time central banks have been fighting something of a war on inflation and inflation expectations.

After the damaging effects of high inflation in the 1970s and early 1980s, western societies welcomed tough-talking central bankers who were determined to achieve and maintain price stability. In recent years, governments (and investors) have increasingly looked to central bankers to also help support economic growth.

Central bankers have examined the Japanese experience of the 1990s and concluded that deflation is indeed a painful and prolonged environment for which there are few policy remedies.

The conclusion has been that even a little bit of deflation is much more unpleasant than a little bit of inflation and should be avoided at all costs.

Central bankers certainly appear determined to avoid deflation and have clearly been aggressive in the past 18 months in terms of reducing interest rates. At 1.75%, short-term rates in the US are now well below the core inflation rate and should be a powerful stimulus to the economy. The question this raises is: how much inflation will result from policies determined to counter deflation?

One way to assess the inflation outlook is to look at leading indicators of inflation such as the Economic Cycle Research Institute’s Future Inflation Gauge, a monthly index of key economic variables thought to provide a lead on inflation trends. The level of the index is less important than its direction – a rising line suggests that inflation pressures will be upward.

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While global inflation is unlikely to be a problem in the current year, if policy settings remain biased toward boosting growth then the inflation outcomes may be higher in coming years.

Locally, recent comments from the Minster of Finance regarding the Reserve Bank of New Zealand’s interpretation of its policy targets suggests that political pressure will also result in a greater tolerance of higher inflation outcomes.

The implication of this for investors is relatively minor, provided they hold sufficient weightings to growth assets such as property and equities. Those who have enjoyed the high real returns from cash and fixed income over the past decade and are positioned for more of the same should recognise that much of the previous performance resulted from a structural downtrend in inflation, which cannot be repeated.

Sector Outlook

US equities –Though negative sentiment may cause markets to overshoot on the downside — just as they overreacted on the upside in the late-1990s boom — our quantitative models are sending signals that current valuations are attractive.

We do not think the equity market's decline points to an imminent collapse in US economic activity, given that household balance sheets remain in solid shape. We continue to favour companies with strong cash flow characteristics.

Non-US equities – We remain positive about continental Europe. Longer term, we are concerned about effects on UK banking stocks of their exposure to residential investment properties.

The Japanese situation continues to concern us. Emerging markets have continued to outperform other markets and will probably continue to do so in an environment of low US interest rates and recovering global economies.

Australasian equities –The slower pace of economic growth being experienced by the US and Europe will affect activity and commodity prices in Australasia and we expect commodity stocks to be volatile until global industrial production begins to show signs of recovery.

We are also cautious about the outlook for valuations within the banking sector as the number of defaults rise in the US. In this environment, we expect non-commodity exporters and those companies with a strong and defendable domestic earnings base will prosper in a relative sense.

Australasian property –Sustainable yields remain high, particularly in New Zealand, and are compelling relative to the prevailing cash rate. Listed property’s safe haven status is notable in light of the relatively high level of market event risk currently afforded to geopolitical events and corporate malfeasance.

We retain a significant exposure to infrastructure assets, many of which we consider to have been unfairly treated in the prevailing bear market given their annuity-style income streams.

US fixed income – We anticipate that a steeply positive yield curve will be a feature of the pro-growth policy stance we expect for some time to come. The implication for investors is that, while bond yields will provide a pick-up in yield over short-term rates, this reflects the reality that conditions are stimulatory for future growth and potentially future inflation.

Non-US fixed income – In the absence of further rate reductions, we are neutral on the outlook for European bond markets. In the UK, last year’s interest rate cuts have proved more than effective. We would become cautious on UK fixed income if the Bank of England is forced to use interest rates to rein in service sector inflation. In Japan, bond yields remain at levels that offer very little reward for investors.

Australasian fixed income – We favour cash over fixed income, recognising that bond markets have already embraced a pessimistic view of global growth and offer little additional reward for any inflation risk.

Currency – Volatility in currency markets is normal, and while we are still somewhat concerned that the US dollar remains modestly overvalued, there could easily be sharp movements in either direction. Over time, the countries with currencies most likely to gain against the US dollar are those with improving external balances, attractive interest rate levels and cyclical industries. The Canadian, Australian and New Zealand dollars appear to be in this category.

Market Assessment- Summary

The sharp decline in international equity prices in June has taken these investments to much more attractive levels in relation to alternative asset classes. Australasian equity markets are likely to be less affected by potential accounting concerns, and the robust local economies should be supportive for growth assets.

Fixed income markets have begun to price in a much more benign inflation environment, which is reasonable considering the increased evidence of a slow recovery. Nevertheless, further capital gains would require a sharp decline in inflation expectations, which is unlikely while monetary policy is so stimulative.

Cash remains a suitably defensive asset class, but we see reduced likelihood of sharp rises in short- term interest rates.

Currency volatility has risen in recent months and we expect this to continue. The US dollar is now less overvalued but investors should still protect themselves from adverse currency movements where possible.

Diversification across all asset types continues to be the key to minimising the impact of market events and exposure to any single asset class at a particular time in the cycle.

This is the summary of Arcus Investment's quarterly strategy paper.

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