One of the old adages of investing is ‘don’t fight the Fed’. With two recent and large interest cuts under our belt, and the prospect of more to come, the stage seems set for the economy to pick up handsomely and equities to resume their upward climb. However, one of the other oft-repeated nostrums is ‘it’s different this time’. Usually this heralds the birth of a new paradigm, blowing away the outdated lines of thought and allowing one to gloss over uncomfortable indications that valuations have become too high.
It could indeed be different this time: the former piece of advice has usually worked in the past, but now, it might not. The main reason for this is the valuations. At the beginning of previous Fed easing cycles, the equity valuations had been far more depressed than the levels we are now seeing. Equity markets are still working off the excessive valuations of the bubble of the last few years in the TMT stocks, and erstwhile value stocks have had impressive rallies since last March.
A second reason why aggressive Fed easing might not have its usual effect on the markets is that the current slowdown has not so much been caused by a monetary squeeze, as it is the result of over-investment. The overhang, especially in the tech sector, is enormous.
The slowdown in the US economy has given rise to much prognosticating regarding the shape of the eventual recovery. By and large, the market seems to expect a V-shaped recovery, starting in the second half of this year. We think this view is too complacent, and that a U-shaped trajectory is more likely – and the aid of other letters of the alphabet has been enlisted at various times to ponder alternative future courses for the economy. The most worrisome would be the dreaded L, an example of which we have seen in Japan in the last decade. While both lower interest rates and tax cuts will help the US economy, the effects are unlikely to be felt until well into the second half of this year. Aside from the economic fundamentals, which are deteriorating, the fall in the US stock market is also having a deleterious effect on consumer confidence. The irony of the situation is that Alan Greenspan is now effectively trying to put some of the “irrational exuberance” back into the market, which he decried just a few years ago. But the irrationality will have to be wrung out of the market sooner or later, and this inevitably means further pressure on equities. The short-term condition may be oversold, but compared to longer historical periods, valuations remain too high for comfort. The discrepancy between value and growth has closed over the past year, but remains historically high, probably resulting in further falls in the broad market averages.
We see European equities doing slightly better than US equities, simply because the outlook for European economic growth is better. We expect domestic demand to drive economic growth in Europe this year, which should come in a good deal higher than US growth. Even so, European equities will not decouple sufficiently from the US to claw their way higher while US equities slide. Tax cuts are providing the support for the European economies right now, helping domestic demand and the service sector take over from manufacturing to drive growth. It will be interesting to watch how European multinationals respond to the recent gains in the euro. Having lived with a weak currency for many years now, a sudden reversal in the euro’s fortunes could put serious pressure on corporate earnings. European multinationals make on average about 20% of their earnings outside Euroland, making them far more sensitive to fluctuations in the currency than the economy as a whole. Only 2–3% of Euroland GDP is directly attributable to trade with the US, for example.
We are underweight equities as a whole, preferring the safety of fixed income. Both US and European growth cyclicals, most notably the TMT sectors, are our main underweight positions, while we maintain overweight positions in value cyclicals. We hold a neutral position in Japanese equities, which at current levels are by far the cheapest equities in any of the developed markets. It is the deep gloom that surrounds the Japanese economy which prevents us from taking an overweight position. The political manoeuvring ahead of the Upper House elections is not likely to lead to any fundamental change in policy, which Japan desperately needs. Reforms in many areas of the economy are long overdue, but have thus far been thwarted by vested interests. Having said that, there is also relatively little downside left in Japan, as the deepest gloom is already priced into the market.
Petr Kocourek is portfolio manager with the asset allocation team at Morgan Stanley Dean Witter Investment Management

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