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Return to normal may take time

Spicers discuss, in its quarterly strategy paper, the nature of the US economic slowdown and the implications for recovery, the debate regarding the degree of undervaluation in the stockmarkets and the characteristics of stocks that investors should feel comfortable owning during the current period.

Monday, November 5th 2001, 10:18AM

This quarter, we focus on the following key themes: the nature of the US economic slowdown and the implications for recovery, the debate regarding the degree of undervaluation in the stockmarkets and the characteristics of stocks that investors should feel comfortable owning during the current period.

What type of recovery can be expected given the nature of the current US slowdown?

We believe that the US economy, which was showing signs of stabilising before the attacks, has probably already entered into a short-term recession. However, the monetary and fiscal stimuli, already signalled by policy-makers globally, will have a powerful effect on economic activity in the next six to 18 months.
Our expectations of the global economy's performance over the next two quarters in particular should not be confused with our view on asset market performance. We believe stocks will outperform other asset classes well before the economy rebounds, as investors look past existing negative conditions and begin to price in a higher level of longer-term economic activity. The effects of fiscal and monetary stimuli will augment the release of pent-up demand.

Are stocks undervalued?

The first week following the US market's reopening on September 17 was among the worst in history. Even before the attacks, our cyclical valuation models indicated that equities were increasingly undervalued. Those models now all point to an even greater degree of under-valuation at today's prices, as do more widely used measures, such as the Federal Reserve's own valuation model and the spread of average dividend yields to short-term Treasury bill yields.

Another way of explaining the current decline in equity markets is as a reflection of a sudden increase in the equity risk premium - the additional return that equity investors demand in excess of the return on 'risk-free' government instruments. While this is a rational response to recent events, it would be unprecedented for the risk premium (and volatility) to remain elevated for a period longer than several months.

In addition, the recent aggressive global monetary and fiscal response, together with accelerated corporate restructurings and buybacks, will add still more support for a rally that should occur well before the economy itself recovers.

The main catalyst to this rally will likely be psychological: a widespread perception that long-term strategies to combat terrorism have been successfully initiated, and that public safety has been restored. However, it is by no means certain that this return to 'normal' will be achieved in the near future. There may be continued setbacks and challenges over the coming months (and possibly years) in restoring public confidence.
The rise in implied equity risk premium is not isolated to the US. Both the European and UK stock markets are at rare levels of attractiveness, while valuations in Japan are also attractive but caution is required due to the perilous state of the economy.

What are the characteristics of stocks that investors can feel comfortable owning?

For equity investors, this is a two-part problem. First, investors must determine the appropriate positioning during a period of high volatility. Next, they must identify the important themes that will drive markets when the volatility subsides.

The recent turmoil has not affected the underlying business models in more defensive sectors such as healthcare, consumer non-durables and utilities, which have relatively steady cashflows and improving valuations.

As equity market risk premiums decline, probably within months, we favour a strategy with a central theme that emphasises economic recovery. By then investors will have had time to assess the impact of the greater monetary and fiscal stimuli now being administered by government policy-makers. Cyclical investments, including select resource, construction, technology and telecom issues, should outperform. More generally, this period should see a recovery in growth equities as well as in small-cap stocks.

Sector outlook

It is rare for global equity markets to be priced for the degree of pessimism that they currently reflect. Not only are equities attractive relative to bond yields and inflation rates, but compared to the low levels of short-term interest rates, they also represent a compelling investment for coming years.

US equities - The sharp initial fall in the US equity market following the terrorist attacks and its significant recovery during October is a typical response to an external shock. Such volatility may persist for some time. Stocks based on their prospects for 2003 and beyond should be looked at, as opportunities to profit from the current short-term volatility are fleeting.

Non-US equities - The outlook for continental Europe is much improved and UK stocks remain appealing with attractive valuations, the Bank of England's easier monetary policy and low inflation all creating a positive backdrop. Despite the strong relative returns achieved recently in Japan, we continue to view the market there with some caution. The outlook for emerging equity markets (particularly for those reliant on foreign capital flows) has worsened following recent events.

Australasian equities - We expect that the Australasian economies will benefit from the effects of global and local monetary and fiscal policy easing, combined with a rebound in consumer confidence. We remain positive on overall market valuation measures within Australasia, although we expect volatility to be a feature of coming quarters as the extent of US and international retaliation becomes apparent.

Australasian property - The Australian industrial property sector retains a high yield/low growth profile. We expect that the outlook for subleased office space within Australia will be sluggish, given major industry players continue to act rationally with little in the way of new developments in the pipeline. We expect retail property to be static in its performance and expect no real capital gain in the industrial property sector.

US fixed income - Central banks worldwide have aggressively reduced short-term interest rates in a coordinated effort to limit damage to what was already a fragile global economy. The anticipated recession will likely delay the recovery of this sector, but yields are now quite attractive and our long-term expectations for the sector continue to be positive.

Non-US fixed income - European central banks have more room to cut rates than their counterparts at the US Federal Reserve. Core European bond markets (primarily Germany and France) will benefit from the post-attack flight to quality, especially in the intermediate maturities. Our outlook on Japanese bonds remains negative. We are currently very cautious of emerging-markets bonds.

Australasian fixed income - Central banks in Australia and New Zealand have followed their international counterparts in reducing rates to offset further economic weakness. We expect the effect on long-term bond yields to be somewhat muted as markets also consider the potential for a stronger rebound in 2002 and a more lax approach to government spending.

Currencies - Expectations of a recession, declining corporate earnings and the likely elimination of the government budget surplus, all bolster our long-held belief that the US dollar is overvalued. We are supportive of the euro against the US dollar. We remained concerned about the yen. Our views on the pound are mixed. While growth in the UK should stand up to the current turmoil, deterioration in the manufacturing and exporting sectors suggests that the currency is still reasonably expensive. We continue to hold a favourable long-term view of the Australian and New Zealand dollars on the basis of the sharp improvement in external balances.

Market assessment

The current undervaluation has resulted from a pendulum-like swing in investor confidence from the euphoria of the dotcom boom to the panic of mid-September. Rational investors should not embrace either extreme, but continue to select investments on the basis of their sustainable cash flows.

In this context it is difficult to be strongly positive on bond markets although they will still provide a way to reduce volatility for more conservative investors. Property will probably be supported by attractive yields, but we remained concerned that only selected exposure to land-constrained industrial sites offers a sustainable return in the long run.

Currency volatility is likely to continue to be high, which may add further to the variability of returns on international assets. Where possible, investors should consider using hedging strategies to reduce foreign currency risk, particularly the risk of a decline in the US dollar.

Aaron Hing is the head of financial planning at Spicers Portfolio Management

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