International Shares

In spite of a sustained period of global economic downturns, international equity markets are having one of the best starts in more than 60 years.

The S&P 500 is up around 5% with surveys of investor sentiment suggesting more bulls/fewer bears than at any time since 1998. This is an extraordinary development given the current position in one of the biggest bear markets in history and the heightened prospect of war in Iraq.

Instead markets have preferred to concentrate on the positives including recent signs that US manufacturing has stabilised

But as we look further into 2003, we reiterate a cautious outlook for international equities, at least in the short term, based on three main concerns:

• There remains a great deal of uncertainty over the global economic outlook. While US manufacturing conditions appear to be improving, overall the US economic recovery is sluggish and much still depends on the US consumer. So far the steep falls in equity markets and consumer confidence, and the rise in the unemployment rate have not been enough to derail the consumer. But clearly there is a high-risk that consumer confidence could slide, particularly if firms cut staffing levels again. Outside the United States, economic prospects are little better - Europe’s economic environment appears to be weakening while there are fears that Japan will fall into another recession, once the current export-led recovery has petered out.
• Geopolitical risks are high. The Middle East and related geopolitical issues will have a big impact on the 2003 outlook – but no one knows by how much. Two things are certain. Companies are unlikely to boost hiring or increase their capital investments while uncertainty over war with Iraq remains. Second, if oil prices remain at current levels, then it will be a measurable drag on real spending power – swinging from an income-boost of around 0.5% of disposable income to a drag of a similar size – resulting in a 1% income turnaround. With debt levels already too high, a further cut in real income would force a slowdown in consumer spending. That, in turn, would keep US growth very low.
• Share prices are far from cheap. Although valuations have normalised from historically high levels, they are still not cheap and profits will be hard to come by in 2003. Indeed by all accounts, 2002 was a lousy year for profits in the United States. While the economy grew by 4% in the third quarter, corporate profits as measured in the GDP accounts actually fell by 7%. Even though corporate profits are likely to recover, the gains are likely to be well below average from an historical perspective. This reflects excess capacity, weak pricing power and more conservative accounting practices. Analysts’ expectations of a 15% rise in US profits this year is almost certainly far too high, suggesting another dose of negative earnings guidance from corporations and further cuts in analysts’ estimates.

That said, we can envisage a situation where the global economy and stock markets surprise on the upside this year. A quick victory in Iraq could reduce uncertainty, freeing businesses to move forward with capital spending and hiring plans, which in turn help consumer confidence and spending.

And with another tax cut coming, households could lift their spending, producing above-trend consumer spending growth rates.

But even if the US war effort goes smoothly, the economy may have more to go in adjusting to the bursting of the stock market bubble.

So far the steep falls in equity markets and consumer confidence, and the rise in the unemployment rate have not been enough to derail the consumer. However, 2002 saw the largest sustained tax rise in at least 40 years, borrowing is slowing and, most importantly, labour income is under pressure from growing unemployment and weaker hourly earnings. A lot will depend on firms’ willingness to boost hiring and increase their capital investment in what has been a jobless recovery so far.

Some market participants are betting that 2003 must be a better year for international equities simply because they cannot fall for four straight years – the last time this occurred was in the early 1930’s Great Depression. I wonder!

Geoff Mason is the manager of investment strategy at BNZIM

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