International shares: Rising bond yields threaten equities
Friday, February 4th 2000, 12:00AM
The really big equity story of the past year has been the insatiable demand for computer, internet and telecommunications shares worldwide. The NASDAQ, the technology heavy index on which new companies choose to list in the absence of an earnings history, has risen some 60 per cent since January 1999. NASDAQ imitators from Germany to Japan have done likewise as investors have lost all interest in dividends in the rush to find companies investing everything in an attempt to be tomorrow’s Microsofts - giants with unassailable market share driven off superior systems and connectivity. A great swathe of US and European companies, many of them with solid earnings growth and inexpensive prices, have been sold down as investors redeploy cash into the "dot.coms". Not that any old tech stock can expect to rise with the tide. Some tech stocks are entirely ignored while a select few surge to unheard of price-earnings ratios. The great bull run in equities continues, but "breadth" is very poor with fewer and fewer companies participating in the rises. Seldom have so few companies owed so much to the mania of so many investors.
What do the fundamentals imply for the global equity markets this year? As usual, the US must be the starting point.
The inspired US economy continues to grow at inflation adjusted rates of 4-5 per cent quarter after quarter. The latest data on the growth in the labour market shows that while job growth is "too fast" for the Federal Reserve’s comfort, and unemployment has fallen to a mere 4.1 per cent with the pool of available labour continuing to shrink, wage growth is not rising. The US economy can seemingly do no wrong, consistently growing at rates that threaten an inflationary surge at some point but all the while enjoying stable core inflation. This is the point of tension in the pricing of financial assets in the US - actual reported inflation remains low, consistently on the benign side of market expectations, whereas strong economic growth and tight labour markets threaten a significant inflation problem in the future. Our view remains that the latter factor will remain a concern for markets until such time as economic growth momentum is seen to be past its peak - which could be in the first quarter of 2000.
In Europe leading indicators of economic activity, business and consumer confidence, new industrial export orders, as well as employment intentions, continue to display improving vitality during 1999. With European interest rates still low even after the unexpectedly aggressive 0.5 per cent rate hike a couple of months ago, and the huge 17 per cent fall in the Euro currency since launch (boosting Europe’s export competitiveness) economic growth should reach between 2 per cent and 3 per cent in 2000. Company earnings growth prospects are strong.
As economic growth prospects in 2000 continue to brighten, the ECB will eventually need to raise interest rates again as a pre-emptive measure against rising inflation expectations. This could well occur by the end of the March quarter of 2000. However, the low level of inflation, namely 1.5 per cent, implies that the monetary tightening exercise need not be severe or protracted, and its adverse impact on the financial markets should be limited. We anticipate short term interest rates will be 50 to 75 basis points higher by this time next year - but still under the 4 per cent level.
Signs are accumulating that the worst of the Japanese recession/deflation is over. Industrial output growth has turned up decisively from very depressed levels and business sentiment has recovered for three successive quarters. The appreciating Yen, rising yields in the bond market, together with the equity market being at its highest level in over two years, are signs of "reflation relief" in the long beleaguered economy. If deflation is indeed over the Nikkei could again be an outstanding performer in 2000.
Overall, the global economy should be a positive driver of company earnings growth and, other things being equal, for share prices.
However, this stronger economic growth holds significant danger for equities given the likelihood of further rises in bond yields. With US economic growth remaining above its long run potential the chances of another 75-100 basis points worth of rate hikes in the US are high. While credit markets have recently recognised the higher chances of rate hikes, and yields have risen, equities have been remarkably immune so far.
While alert to the risks, and also noting the "poor quality" of this equity bull market (with a majority of share prices languishing while selected computer and telecommunication stocks rise ever higher) we still expect that all the major equity markets will move ahead over the rest of this year.
Michael Daly is manager investment strategy for Bank of New Zealand Investment Management.
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| « Property: Yields look to firm up this year | NZ economy: Three key factors drive market » |
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