Japan a worry of investors

This quarter, we focus on the following key themes: the evidence of a recovery in global economic growth, the potential for divergence in global interest rates, and the risk of Japanese led Asian currency devaluations.

The evidence of a recovery in global economic growth

We see many reasons for optimism that the US economy and corporate profits will be on the upswing by the second half of 2002 and once again act as an engine for global growth. The key factors are that productivity has held up well in this recession and will likely be sustained in coming years, energy prices have trended lower and are likely to remain moderate over the next few years and most persuasively, policy settings are now at extremely stimulative levels.

The initial stages of the recovery will be characterised by inventory rebuilding. Declines in production during 2001 were much greater than those in demand. The implied reduction in inventory levels indicates one of the most significant periods of de-stocking in many years. Provided demand continues on a steady path, one of the first actions by US corporations will be to restore inventory levels. Similarly, the steep decline in corporate capital expenditure during 2001 is likely to be at least partially reversed as capacity utilisation rises. Although we do have some concerns about the impact of the Enron collapse and Argentine crisis, we do not expect these events to constrain recovery within the US. Its banking system’s capital position is strong and much improved from the last recession in the early 1990’s.

Corporate restructurings, sustained productivity growth, lower energy and material prices, and monetary and fiscal stimulus should lift the US economy out of recession in the first half of 2002 and improve corporate profits in the second half.

The potential for divergence in global interest rates

Not only was 2001 notable for the aggressive global easing of interest rates, it was also a year of unusually synchronised central bank action. Central bankers differed little in their views of the risks to world growth and their actions were only distinguished by differing degrees of action rather than direction.

With signs of stabilisation in the world’s major economies, it appears that only modest further easing will be required in some countries this year.

Current low interest rate levels should provide considerable economic stimulus. Some economies may respond more vigorously than others and 2002 could well be a year of divergent interest rate policies, with a number of countries making further cuts while others begin to raise rates toward the end of the year.

The implication for investors is that, while growth assets remain attractive, there may be greater interest rate and currency volatility. Investor sentiment will also remain volatile, as economic news will appear to support low interest rates in some countries and higher rates in others.

The risk of Japanese-led Asian currency devaluations

The Japanese finance minister’s call for the country's central bank to further ease monetary policy weighed heavily on the yen as it declined to three-year lows and sparked fears of competitive devaluations in the Asian region (for a precedent consider the Asian crisis of 97/98). We consider that resolving Japan’s deflationary problems via a precipitous currency decline could, in effect, export the deflationary forces to the US and Europe. Such pressures would present challenges for policy makers on both sides of the Atlantic and could prolong the current slowdown.

Sector Outlook

US equities - Developments suggest that economic fundamentals rather than the ebbs and flows of investor risk aversion will begin to drive markets in the months ahead. Stock selection skills rather than market or sector-based allocation strategies will be the key to successful equity investment in 2002. Those companies that can generate strong cash flows, maintain or lift margins through productivity improvements, exhibit pricing power in their product markets, and remain well managed either as industry leaders or emerging players will be rewarded with rising stock prices.

Non-US equities - The relative out-performance of sharemarkets outside the US should be sustained in the months ahead. We are encouraged by the interest rate cuts we have seen from the European Central Bank since September. UK stocks remain attractive, although not to the same degree as their European neighbours. We continue to be cautious on Japan given that the country’s long-stagnant underlying business environment has prevented its market from offering the compelling valuation disparities elsewhere. We expect emerging markets to be among the major beneficiaries of a sustained global economic upturn.

Australasian equities - Our modelling now suggests that, although Australian and New Zealand equities remain attractive in an aggregate sense, the degree of apparent valuation disparity across the investment universe has diminished.

Australasian property - The Australian listed property sector significantly under-performed the broad market through the December quarter. This reflected equity market strength as investors began to price in an impending global cyclical recovery driven by concerted monetary easing and fiscal stimulus, which in Australia includes the First Home Buyers grant. In the coming period, we expect capital values to remain relatively stable for listed property in both Australia and New Zealand. Infrastructure assets continue to be favoured.

US fixed income – US treasury bonds are likely to struggle as the economic momentum turns. Better investment opportunities exist in non-government bonds.

Non-US fixed income - While European economies will benefit from the US recovery, they may lag behind as a result of the reduced degree of monetary stimulus. We are now even more negative about Japanese bonds as a result of the recent credit-rating downgrades of Japan’s sovereign debt and bank securities.

Australasian fixed income - It is now apparent that both the Reserve Bank of Australia and the Reserve Bank of New Zealand have avoided recessions in their economies by pre-emptive easings earlier in 2001 and further rate cuts after September 11. Consumer confidence and retail activity are improving and business confidence is beginning to follow. High volatility in yields is expected to continue and any sharp rallies in bond prices may provide the best opportunities for investors to shift portfolios toward growth assets.

Currencies - Our stance on the US dollar remains negative due to the high external financing requirements of the US economy. European policy makers have more room to boost growth and we retain a positive view of the euro. A feeble domestic economy and continuing bad-loan woe in the Japanese banking sector leave us concerned about the prospects for the yen.

Our most positive view is on the Australian and New Zealand dollars. Strengthening domestic economies, improved export incomes, favourable interest rate differentials and the potential for greater inward merger and acquisition activity all bode well for these currencies.

Market assessment

Equity markets have rallied strongly as fears related to the war on terrorism have receded. The debate on equity valuation is now focused on long-term earnings potential rather than short-term event risk. This is a somewhat more rational situation than existed only a matter of months ago. In the absence of such significant macro market opportunities, investors should have more modest expectations of total returns.

One remaining anomaly is the low levels of global interest rates. While some countries can be expected to see rates rising this year, a broadly stimulative environment can be expected to persist for some time. Investors should position themselves in asset classes likely to benefit from both the low cost of funding and the potential flow of funds. Australasian equities, international equities, and property and infrastructure assets can be expected to perform well under these conditions.

Fixed income assets may experience some volatility as sentiment over the economic cycle shifts, but many sectors of the bond markets will still provide attractive returns for risk. Currency volatility could also rise if economic cycles diverge and we recommend that investors minimise their exposure to the US dollar in particular.

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

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