Prospects for Global Economic Activity and Financial Markets in a World Gone Mad
Two years ago, the perennial optimists were arguing that the setback for the
US economy in 2001 would prove a temporary affair and the oft-postulated view
was that the US economy would experience a V-shaped recovery, resulting in a
quick improvement in the fortunes of the rest of the global economy. This optimistic
view has proven ill founded; the last couple of years have been very difficult
for the global economy and for global financial markets. Today the global economic
situation can be summarised as follows.
Governments & Central Banks have reacted to the economic weakness with
increased spending and lower taxes where possible, and significantly lower interest
rates. To date these policies have failed to have much impact, due largely to
2 factors, geo-political uncertainty and the legacy of the bubble that burst
in the US in 2000. With the ending of the Iraq war, US business and consumer
confidence are set to bounce back quite strongly, but it is still far from certain
that the expected rebound in business and consumer confidence will be sustained
and result in significantly improved levels of real activity over the coming
months.
The key impediment to recovery in the US is the fact that the economy and corporate
America are still working through the legacy of the bubble economy. The key
characteristics of this bubble were a massive and unwarranted boom in the IT
sector, substantial over-investment by business, and high levels of consumer
debt. As a consequence, corporate behaviour is still characterised by balance
sheet restructuring and repair, and consumers are trying to pay down debt and
are generally cautious in the face of uncertain employment prospects. Until
the US gets back on a stronger growth path, the rest of the global economy will
struggle.
On balance it is likely that the global economy will gradually emerge from
the current economic malaise over the next 18 months, but we are not going to
see a return to the sort of growth that characterised the global economy in
the second half of the 1990s for some time to come.
In terms of the investment climate, life is not easy at the moment whether
one be an investor or somebody trying to attract investors into the market.
Looking at the various investment options at the moment does not prove terribly
inspiring.
On the interest rate front, it is likely that the ECB will cut another 0.5%
off short-term interest rates over the coming months, and it is possible that
the Federal Reserve could take another 0.25% off its rates. Indeed, it looks
likely that global interest rates will remain at current low levels over the
next 12 months at least, and on a 3-year view it is difficult to see much upside
potential. Consequently, keeping money on deposit will not prove very lucrative.
Fixed interest markets have become popular investment vehicles in a very uncertain
and risky equity environment, but the prospects for this asset class also look
modest. 10-year rates in the euro zone currently stand at 4.1%, in the US 3.9%
and 4.4% in the UK. In a historical context such rates are exceptionally low
and it is not appealing to tie up money for such a long period for such a low
rate of return. It is likely that over the next 12 months that long-term rates
will rise, and bond prices fall, from current levels due to the anticipated
economic recovery, and increased supply of government paper as budget deficits
widen. For investors in fixed interest, there is not a lot to go for at the
moment, but if an investor has a short-term horizon and is risk averse, then
fixed interest is one of the only options available. Bonds do not look good
value relative to equities at the moment. For borrowers, the current level of
long-term interest rates is as low as they are likely to go in all markets,
so the risk averse should now consider fixing.
On the equity front the last three years have been awful, with 3 consecutive
years of negative returns. This is only the third such occurrence over the past
century, the others being 1929-32 (the Wall Street Crash), and 1939-41(the 2nd
World War). Over the period 2000- 2002, it is estimated that $13 trillion has
been wiped off global equity market values, equivalent to $2, 000 for every
man woman and child on the planet. Wealth destruction of this magnitude has
seriously damaged economic activity and has created a very negative perception
of equity markets from investors. This will prove difficult to repair.
2003 started off badly, with the uncertainty surrounding the Iraqi War instrumental
to this negative performance, but since the ending of the war markets have rebounded.
Most are now back in positive territory in the year to date, but there are still
many challenges ahead. It is likely that 2003 will see a breaking of the 3-year
losing streak, but we are still looking at modest gains this year, of circa
5% on global equity markets.
Looking at prospects for equity markets, two things are essential for a market
recovery, stronger economic activity and stronger earnings growth. Both of these
are likely over the coming year, but they are likely to be of relatively modest
magnitude. The problem is that the US economy and US markets will have to lead
the world out of the current difficulties, and while this is likely, the US
economy and US companies will need time to purge themselves of the excesses
that built up in the second half of the 1990s. This process will hamper expansion.
On the property investment side, the outlook is also less than clear.
Commercial property has lost its shine over the past couple of years, as rents
have fallen and vacancies rates have risen against a background of a slower
domestic economy. This situation is unlikely to change for the moment.
Retail is still strong, but with Irish consumer behaviour now becoming more
subdued, this market looks close to its peak and could come under some limited
pressure over the coming year.
On the residential side, the picture is murky and care is needed when investing.
The key risk to the Irish housing market would emanate from a sharp employment
shock. It does not matter how low interest rates are, if one loses one’s
job, then a mortgage becomes unaffordable. A major employment shock prompted
by the US multinational sector would very quickly bring the Irish housing market
crashing down. Consequently, observers of the Irish housing market should watch
developments in US corporate boardrooms rather than domestic developments.
In the aggregate, housing supply has now matched demand, implying that house
price inflation should level off. However, in a locational sense supply rarely
matches demand. In effect this means that in established areas with limited
supply, strong demand should ensure that prices can continue to rise strongly.
Over the coming years location will be the most important
factor driving house prices. Investor demand for residential property will remain
strong despite weaker capital appreciation and rental growth. After three very
painful years for equity investors, property will be seen as the investment
vehicle of choice, with many investors likely to prove reluctant to invest in
equity markets. Be wary of stockbrokers predicting an imminent collapse in house
prices as they have a vested interest in re-awakening investor demand for equities.
Other investment vehicles that could significantly enhance return are hedge
fund products. Hedge funds still represent a minority investment vehicle, but
they are very worthwhile and should be considered by the slightly more adventurous
investor as an essential part of the overall investment portfolio.
It is clear that all investment asset classes are shrouded in uncertainty at
the moment and investment returns over the next couple of years are likely to
be much more modest than in recent years. To enhance returns, skill will be
needed whether it is in choosing stocks or properties. There will now be a return
to the fundamentals of investment, with issues such as location essential for
property investors, and for equity investors, factors such as the quality of
management and the product will become all-important. Through careful stock
selection it will be possible to significantly enhance investment returns in
an environment of generally more subdued returns.
In general investors should consider factors such as the time horizon, with
equities a better long-term investment, the quality of the fund manager or stock
picker, the amount of risk that one wants to take, and above all else a diversified
portfolio is essential.