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Surprises will continue, but some will be pleasant

Jardine Fleming outlines what it sees happening in global markets.

Friday, November 20th 1998, 12:00AM

by Philip Macalister

In October the all important question was ‘Is the worst over for markets’? The key underlying message just a few short weeks later seems to be that, yes, it is. We are seeing some signs of investor optimism returning to the markets and the general economic outlook now seems a little less uncertain with a rebound in Asian markets being the major contributor to healthier market sentiment.

 

In the United States the tide of investor opinion does appear to be turning. Gross domestice product growth for the third quarter was nearly a third higher than expected at 3.3 per cent, which served to boost confidence in all global markets. Concerns about a capital markets credit crunch have been met most recently by yet another interest rate cut by the US Federal Reserve, the third in 7 weeks.
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Unfortunately the unwelcome corollary so far has been to give the US consumer reason to believe that lower share prices were just a bad dream. What is required now is for US investors to wake up to the fact that all is not well in the US economy.

We may not be heading for a recession, but we are heading for a significant slowdown. Instead, consumers continue to spend significantly more than they earn, which will make the shock of a downturn, either in stock prices or the real economy, that much more dangerous. Hopefully this last interest rate move will be seen to be in response to the real domestic problems facing the US.

Shorter term, however, Latin America will continue to be at the forefront of investors’ minds given that it is perceived to be the Achilles heel of the US economy, representing a fifth of all US trade.

The success of the aid package and austerity measures in Brazil are of paramount importance for the Latin American region as a whole. Devaluation of the Brazilian real would have a snowball effect on all other Latin American currencies and could seriously upset the economic apple cart.

Furthermore, the devastation caused by Hurricane Mitch in parts of Central America, may impact on the region as a whole. Nevertheless, the current outlook is more positive than it has been since the start of the problems in emerging markets and the aid package will give the region an important head start in rebuilding economic stability.

Europe and the UK
The United Kingdom market has ridden the global optimism from Asia and emerging markets, particularly Latin America and Eastern Europe, but domestic economic figures do not appear to justify current stock valuations.

In our view a correction is not inconceivable but will depend on the direction of interest rates. Case in point is the Bank of England’s 50 basis point cut on November 5 which came as something of a surprise.

The market had been expecting nothing more than 25bp. Even more surprising, however, was the market’s reaction (2.6 per cent point fall) which suggests that central bankers are more concerned about the economy than previously thought. In the rest of Europe, inflation is dropping reaching a mere 1 per cent, year on year in September. This suggests that the Eurozone is probably entering a period of consumer price deflation.

Japan
The outlook for Japan remains somewhat cloudy. A stronger yen is likely to continue to raise concerns over export profitability, while the sluggish domestic economy shows no sign of a recovery. However, it’s not all doom and gloom. Further news of banking sector consolidation is likely to be greeted with optimism and there are signs that some investment companies are now seeking to increase their exposure to the Japanese market.

It should be said however that any denouement is likely to unfold with the torpor of a Noh drama and the plot twists of a Mission Impossible. Still, we are hopeful that the faint glimmer at the end of the Japanese tunnel is a new dawn and not the headlights of an oncoming Shinkamren bullet train.

We remain cautious over the recent gains in some of the Asian markets. While a strengthening Japanese yen has increased the competitiveness of regional exports, the region is still in the midst of an economic slump and many companies are struggling to service their massive debt repayments.

Consequently, concerns are likely to be raised as to whether the corporate earnings outlook justifies recent stockmarkets gains. Buyer beware.

Eastern Europe
Eastern Europe has managed to pull through from the adverse effects of the fallout in the emerging markets over the last quarter. Thus, the realisation has dawned that, Russia apart, the economic fundamentals are basically sound and the companies are some of the most promising in emerging markets. This is something we have been advocating for quite some time now and are delighted to see that others are finally coming to the same realisation. Immediate-term, while we feel that there may be some imported turbulence into these markets (no matter how positive the domestic situation), we do expect further improvement over coming weeks.

The crisis has consistently surprised financial markets, both by its victims and now by the policy responses to it.

The surprises will continue, as sub-2 per cent world growth in 1999 squeezes the most precarious economies and punishes risk-taking lenders.

There will be further repercussions from victims of the effects of high short term volatility, especially those highly leveraged organisations: it is worth bearing in mind that most hedge funds allow redemptions only quarterly.

For the western economies, muddling through looks to be the most likely outcome.

To conclude, no irrational exuberance here, only cautious optimism with a bias in favour of the UK and US.

This article has been prepared by Jardine Fleming NZ Management Ltd, which is part of Fleming Asset Management, London.

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