Risk-taking Should Once Again be Rewarded

Oliver Adler looks on the brighter side of things, and advises on risk-taking and other economic opportunities in 2003.

Having begun 2002 with high hopes for recovery, economic growth faltered in many regions in the course of the year and the major stock markets turned in one of the worst performances of the post-WWII era. Will investors be disappointed yet again in 2003? While there are certainly quite a few things to worry about on both the political and economic front, chances of a good performance are now much improved, for stocks are simply no longer expensive, and expectations are far more moderate.

All That Went Wrong in 2002

Many things happened in 2002 to make it one of the worst years in global stock market history. Firstly, economic growth was much weaker than hoped for as the slowdown in Europe, parts of Asia and in Latin America offset the recovery in the United States. Secondly, and possibly more important were continued disappointments regarding corporate profits: having dropped precipitously in 2001, expectations for a strong rebound were simply overly optimistic. Thirdly, and possibly even more damaging were the series of high profile corporate accounting scandals and bankruptcies. Fourthly, the increasing threat of a military conflict in the Middle East added to investor pessimism as the year wore on. And finally, with valuations (as measured, for example, by P/E-ratios) still quite high in early 2002, stock markets simply proved far more vulnerable than most, including ourselves, had expected.

Geopolitical Risks and Some Opportunities

International flash points remain of major concern for investors as we go into 2003: the conflict between India and Pakistan has by no means been fully resolved and North Korea is playing a high risk nuclear game to extract concessions from the United States. Of more immediate concern is obviously the situation in the Middle East. A military conflict in Iraq is highly likely in the early winter months. While the military balance quite clearly favours the United States, a prolonged and risky battle for Baghdad could evolve. It also remains to be seen whether a stable post-Saddam regime can be imposed in Iraq. Financial markets currently appear to be ignoring such risks. Any turn for the worse would upset their balance. On the other side, the potential for positive change tends to be forgotten as well.

A settlement of the Israeli-Palestinian conflict is more likely than generally assumed. And in Europe, as well as Japan, the intensifying pressure for economic reform may lead to some positive action.

Economy: Starting from a Low Base

Notwithstanding the major geopolitical themes, the dominant factors for financial markets will be economic in nature: the evolution of economic growth and corporate earnings will be central to the outlook.

In contrast to the beginning of 2002, the immediate economic outlook is quite bleak. US growth slowed in the fourth quarter of 2002 and will only pick up very gradually. Consumer spending which supported GDP growth in 2002 has lost a lot of steam as the employment situation has deteriorated, and investment spending is recovering only very slowly. Growth in Europe is likely to remain weak for longer than in the United States. The European Central Bank (‘ECB’) has delayed cutting interest rates, and fiscal policy is less supportive. Germany is suffering most from a combination of high real interest rates and a variety of unresolved structural problems. The UK economy is still doing better than continental Europe but a setback in the housing market is looming. Asia, outside of Japan, and China in particular, will remain the growth leaders in 2003. But economic activity in some of the leading economies, including Taiwan and Singapore itself, while stabilising, is still rather weak. The Asian picture is darkened by the fact that Japan seems to be moving back into a recession after enjoying an export-led recovery in 2002.

One advantage of the current situation is that we are starting from a very low base, both in actual numbers and as regards expectations, so gains are not too hard to achieve. An acceleration of economic activity is, in fact, quite likely in the course of 2003. First of all, if the Iraq risk is removed, corporate sentiment will likely improve across the globe and some delayed spending plans will be re-activated. In addition, the Bush Administration seems very intent on pushing a further fiscal stimulus package through Congress. George Bush Jr wants to avoid his father’s electoral fate. With the Federal Bank likely to keep interest rates at very low levels well into 2003, better economic momentum seems most likely in the second half of 2003. In Europe, the ECB may cut rates further, and a new central bank governor in Japan may opt for a more aggressive monetary stimulus plan as well. Taken together, global growth should be somewhat higher in 2003 than in 2002 and, most importantly, it should accelerate in the second half of the year. This also suggests that corporate profits will continue to rise across the globe.

A Year for Equities?

Will this suffice to make 2003 a year for equities? While our return expectations are quite moderate, we nevertheless believe that stocks should turn in a reasonable performance. Given the many political and economic risks, market swings are once again likely to be very substantial, but we are rather confident that by year’s end, stocks will have outperformed the other major asset classes (bonds and cash) quite handily. In contrast to a number of bears, we believe that equity valuations are now well within a fair range. P/E-ratios based on our 2003 earnings expectations are all between 15 to 20. Such valuations are appropriate and sustainable, especially if the risk of war subsides. Our return assumptions for world equities average about 10%. The room for disappointments has also been reduced. While analyst expectations of earnings growth and stock returns may still be somewhat high, the rate at which these expectations will need to be revised downward is much less dramatic than in the past two years.

We believe that US stocks will tend to perform better than others in the early stages of 2003 because the economic and earnings recovery is further along. A weaker dollar will also benefit US stocks while tending to harm European and some Asian markets. (That the dollar will lose more ground, seems very likely, given the still huge US current account deficit.) Japanese stocks are no longer out of line in terms of valuation but the weakening economy and policy confusion suggest the market will struggle.

High Quality Bonds are Living Dangerously

While stocks suffered huge setbacks, the year 2002 once again saw extraordinary gains in high quality bonds. This pattern, too, is likely to change: the gains on bonds were not justified on fundamental grounds, ie they did not result from a decline in the inflation trend, but came about because of fears of recession and the flight from volatile stocks. If stocks recover, high quality bonds will suffer. Moreover, the prolonged phase of easy monetary policy in the US suggests that an eventual rise in inflation is more likely than deflation; the rapid rise in the US fiscal deficit poses an additional risk to US bonds. While bond markets in the Euro area should do better, a sell-off in US bonds will not go unnoticed. In contrast, corporate bonds, especially the higher risk groups that were under pressure last year, should benefit from improved corporate earnings and subsiding defaults. Putting it all together, asset returns look to normalise: the ones that are traditionally more risky — stocks and high yield bonds — should finally outperform the ones that are not.

Oliver Adler
UBS Private Banking
For inquiries: econtactasia@ubs.com