Market Review: Equities have won the battle but will they win the war?

The contrasting views (and direction) of bond and equity markets in the June quarter ended abruptly in July, with a substantial sell off in global bond markets. US 10 year bond yields rose from 3.5% to 4.4%, their highest monthly yield rise since 1988. While the New Zealand market was not immune it performed slightly better, with the domestic 10 year Government Bond up from 5.3% to 5.8%.

So why did bonds blink first?

There were a whole host of factors but essentially a consensus view formed that the significant fiscal, monetary and currency stimulus is starting to work for the US economy, raising growth (and therefore inflation) expectations. Just as importantly during July the Chairman of the Federal Reserve, Alan Greenspan downplayed the risk of deflation and therefore whether the Fed needed to address this risk.

At the same time equity markets were boosted by a solid US second quarter corporate earnings reporting season. While allowance must be made for companies lowering expectations prior to the release of their results, corporate earnings still exceeded analyst forecasts by a higher than usual margin. More importantly, analysts raised their, already high, earnings growth assumptions for the 2003 second half. This factor helped fuel a 2.9% rise in global equities in July (MSCI World Index in local currency).

While the move up in bond yields was not a complete surprise (and in fact was highlighted as a significant risk in some of our recent monthly commentaries) the size of the adjustment was beyond most commentators' expectations. Mutual fund flows in the US suggest that many investors had "parked" their funds in cash or bonds waiting for a clearer direction and then abruptly into shares as their confidence grew.

Yield moves were also accelerated from some investors being leveraged into bond markets through undertaking a so-called "carry trade"; borrowing at low short cash rates and investing into longer dated bonds. This works fine until capital losses occur, as was the case in July, and then positions need to be unwound quickly to minimise the damage.

Although the magnitude was unusual bond sell-offs do occur frequently, usually as inflationary expectations increase. It is a painful adjustment period to go through for existing bond holders as their portfolio valuations decline because of the rise in yields. Once a sell off is complete, investors enjoy the benefit of the higher rates on any new bond investments made. Conversely some mortgage holders' rates start to rise, which may impact on buoyant residential housing markets, in the US in particular.

Looking forward the outlook for the equity market is not as rosy as the returns of the past four months might suggest for three main reasons:

• 1. US companies are prepared to take the hard decisions and shed labour where necessary (in contrast to many European and Japanese firms). While this underpins US corporate profit numbers for the last two quarters of 2003, it does temper the 2004 economic outlook as unemployment levels may rise from here. This, in turn, could lower consumer confidence at a time when this (and resultant high consumer spending) is needed to keep the US economy going.
• 2. The US economy continues to have major imbalances with large fiscal and trade deficits. If these imbalances are not addressed the US dollar faces further downside with the risk being a significant and dramatic fall if their economic recovery stalls.
• 3. The negative impact on equity valuations from rising bond yields. This increases the discount rate used in valuing companies, thereby lowering analyst valuations and share price recommendations.

Our view is that much of the gains for the year have been made in global sharemarkets and they will be doing well to be much higher by year end from where they are currently. Conversely with very low short term rates and some economic uncertainties, the bond market sell off may have run its course – although getting in the way of a bear market and picking market turning points is fraught with danger!

Looking back on the actual numbers it was another strong month for offshore share markets, particularly for European markets such as Germany (DAX) up 8.3%, France (CAC 40) up 4.1% and the UK (FTSE 100) up 3.1%. While overall US markets were quieter (S&P 500 up 1.6%), the technology sector continues to hum with the NASDAQ up 6.9% for the month and almost 30% since the end of March.

After being an out performer over the past few years the New Zealand sharemarket significantly under performed its global counterparts in July, being down 3.0%. This reinforces its status as a low beta, defensive market which does relatively better when times are tough and struggles when the major economies on the mend.

While this may seem at odds with New Zealand's narrow (and therefore higher risk) economy, it is consistent with the composition of our market which is dominated by Telecom (a relatively low risk utility stock) and exposure to "soft" agricultural commodities. This is in contrast to Australia, with its resource base, which are known as "hard" commodities. These are more sensitive to world economic cycles and do much better when global economies are picking up. So it proved with the Australian sharemarket up 1.1%, one of the few times in July where the Aussies had it over us!

To see how the numbers stacked up for various markets around the world in the past month and over the year, visit our Monthly Market Reveiw here

Anthony Quirk is the managing director of Guardian Trust Funds Management

Anthony Quirk is the managing director of Guardian Trust Funds Management.

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