International Shares
Global recovery finally here, but doubts still remain over its sustainability
Wednesday, February 4th 2004, 10:52AM
Last year international shares had their best rise since 1999. The S&P 500 rose 26%, the NASDAQ soared 50% while the Nikkei and the German DAX were up 24% and 37% respectively. However, it was not all plain sailing. Investors had to initially contend with a rise in risk aversion and a steady fall in equity prices prior to March (when the war in Iraq began). But the trend quickly reversed once it became obvious that the war in Iraq would be short. From then onwards, global equity prices rallied hard with improved financial conditions playing a key role in reviving the global economy and company earnings in 2003.
As we look into 2004, some fears have receded. War is not looming on the horizon as it was a year ago. That said, geopolitical risks are likely to remain a feature of the global landscape in 2004. Since the war ended in May 2003, tensions in Iraq and terrorist bombings allegedly linked to al Qaeda have increased and the pre-Xmas upgrading in the US terrorism risk level is a reminder that the threat has not disappeared.
Fears over the global economy also appear to have receded. After fretting over whether economic activity would accelerate, economic data in the second half of 2003 has tended to confirm that the long awaited global recovery is finally here. In particular, the US economy has performed above expectation, surging 8% annualised in the third quarter 2003. Loose fiscal and monetary policy has kept the consumer spending and, in turn, this has helped corporate profitability to improve. The US expansion also appears to have reached a self-sustaining stage, with corporate profits up and signs that demand for new capital and labour is improving. Growth has also surprised on the high side in both Asia and Japan, although the Euro area has tended to disappoint undermined by a strong currency and weak domestic demand. The consensus is that global growth will improve in 2004, with the US remaining the leader.
In an environment of stronger economic growth, investor attention appears to have shifted to the prospect of rising interest rates. In 2003, macroeconomic policy was aggressively stimulative throughout the world. Central banks cut their policy rates to record lows. In the US, there was also a huge fiscal stimulus and the US dollar weakened sharply. With the long-awaited global recovery finally here, the expectation is that policy will need to become more restrictive in 2004. However, they appear to underestimate the scope for central banks to remain accommodative. Low inflation prospects in the US and Euro area and the likelihood of persistent deflation in Japan, suggest the scope for monetary policy remaining easy is more substantial than most have considered. The US Federal Reserve has also been working to discredit the idea that a solid recovery provides a compelling backdrop for a tightening in 2004. To be sure, events have relaxed much of the heightened concern about deflation risks that gained prominence in 2003, and policy will need to move towards restraint at some time in the future. However, the urgency to do so anytime soon is lacking.
Even though the equity world is unlikely to face substantially rising yields in 2004, we are still cautious about the prospects for equities in 2004. On the upside, US financial conditions have created a strong tailwind for the global economy heading into 2004. However, a large portion of this has already been widely acknowledged and discounted in prices. While mortgage equity withdrawal and tax cuts have been an important source of income for US households, in 2004 the impact of this stimulus will fade. This makes it imperative that employment growth is sufficient to fill the gap left by the fading impact of this stimulus. The evidence so far has been mildly encouraging. Monthly non-farm payrolls have grown by around 82,000 in the four months to November. However, a more sustained turn in the US labour market is needed. Prior to the recent downturn, the US labour force grew by an average of 141,000 workers a month. To stabilise the unemployment rate, the economy needs to generate the same number of (net) new jobs a month. While the recent momentum in the US labour market is good, the recovery is not generating enough jobs to be totally out of the woods yet.
Valuation considerations may also cap further equity upside this year. At about 19 times this year’s estimated earnings, global equities do not appear cheap. Overall, investors should be wary about the promise of “big returns” in 2004.
Geoff Mason
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