Bermuda: Quarterly Investment Forecast

Recovery in the US economy will start in the first quarter, but the strength of the subsequent growth rate will depend on the ongoing need to resolve inherited imbalances. Economic growth in the United States will help to generate a rebound in activity in Asia and Latin America (barring Argentina), later in the year. The Japanese economy will continue to struggle, despite the unfolding of a more positive global scenario. Growth in Europe will be lethargic, with out-performance in France and the United Kingdom. Major Eastern-European economies will also perform well, led by Russia.

The rate of inflation will decline in the United States, as well as in the Eurozone. Weak labour market conditions will maintain wage discipline, while energy and raw material prices will generally remain low. Excess capacity and tough competition will prevent firms from raising prices. Increased federal government spending in the U.S. and the consequences for higher budget deficits will begin to loom larger in formulating expected future inflation, for investors with longer-term horizons. Japan will continue to experience deflation.

The unemployment rate in the U.S. will continue to rise even as recovery gets under way, and this will prevent the Fed from raising interest rates in the first half of the year. But the authorities cannot afford to maintain the current degree of looseness in monetary policy for too long, particularly if the rebound in the productivity growth rate is not as rapid as expected. The European Central Bank may engage in a modest cut in interest rates in the first half of the year because of sluggish economies and declining inflation. At the Bank of Japan, a zero interest rate policy and quantitative easing are set to continue.

The Treasury yield curve is likely to start flattening as the year progresses, and begin to shift slowly upward. This does not rule out possible correction to oversold conditions for certain issues, in the first quarter. Spreads for high-grade corporate bonds are likely to decline. These developments also apply broadly to the Eurozone, with the difference that at the short end of the curve there is a possibility of an initial decline in rates corresponding with action by the European Central Bank.

Many equity-market indices in Europe, Asia and the U.S. had a good run-up in the final months of 2001, in anticipation of recovery this year. Positive sentiment and liquidity have driven valuations upward and soon it will be time for actual earnings growth numbers to confirm or disconfirm expectations. Given the difficult pricing environment and tough competition faced by corporations, it is likely that the return to high profitability will be a challenge for many firms. Investors will search for value among aggressive growth stocks, small caps, as well as emerging markets.

With the U.S. economy expected to pick up sooner than the Eurozone, investor sentiment is likely to be favourably disposed towards the dollar in the first half of the year, to the detriment of the euro. Lost ground is likely to be regained by the European currency in the second half of 2002. Given that both monetary and fiscal policies are proving to be relatively ineffective as policy tools, Japanese authorities may have to rely on a weaker yen to keep the economy afloat. The outlook is for a gradual depreciation of the yen vis-à-vis the dollar and the euro.

The American consumer has continued to act as the main source of strength in the economy. Households have refused to cave in to pressure from terrorist attacks and deteriorating labour market conditions. The recessionary conditions that prevailed in the last two quarters of 2001 were remarkable in two ways. First, the housing sector has remained robust, and this was helped immeasurably by the massive interest rate cuts carried out by the Fed. Second, households have been able to continue to borrow on fairly easy terms, even as economic conditions worsened. These phenomena did not occur in previous recessions. Consequently, consumer spending has been sustained at the cost of further deterioration in household finances. As a result, a deeper recession has been avoided and a quicker rebound in the economy in the first quarter is likely, but this may also put constraints on faster sustainable growth in succeeding quarters, as attention needs to be focused on repairing somewhat rickety balance sheets.

Capital spending has continued to plunge and a quick rebound is not on the cards. The main reason is that this sort of business spending is insensitive to falling interest rates, being driven primarily by sales growth, tight capacity and profitability. Firms are finding ways to delay new spending and getting more mileage out of their current hardware, software, plant and equipment. Outlays that were previously thought essential to maintain a competitive edge are now being treated as discretionary. Spending on capital goods, particularly on technology, will not be the leading factor in the coming recovery. In addition, some of the expenditure necessary for enhancing security will, in general, not increase productivity but rather detract from it.

Oil prices declined significantly after the September 11 events. OPEC’s ability to maintain a floor price is only feasible if non-OPEC producers co-operate in supply management. The success of this strategy is as much an economic as a political question. Given the background of weak demand and competition among producers, there continues to be downside risk for oil prices. Meanwhile, metal prices have experienced a rebound that appears to presage economic recovery. However, there is also an element of speculation involved, as global demand has yet to pick up strongly.

The decline in industrial production has moderated and the stage is being set for stronger activity in the first quarter. Extensive inventory liquidation is preparing the ground for the need to increase output to meet demand – even if that may sometimes mean just replacement demand. This will have multiplier effects on the rest of the economy. More traditional sectors of the economy will probably be first in line, before the impact is felt in the technology sector. As the capacity utilisation rate remains low, it will be a while before firms experience any production constraints.

Consumer confidence recovered quite well from the after-effects of the September 11 events. A number of factors have been crucial in bolstering confidence: successful conduct of the war in Afghanistan, low interest rates and the rise in stock market valuations in the fourth quarter of last year. However, labour market conditions will continue to be difficult, as firms try to shore up profits by cutting costs, which includes layoffs. As a consequence, the unemployment rate will increase further before levelling off. Households are still quite optimistic about the future, as indicated by a rise in the expectations (forward-looking) component of the Conference Board index. But, if labour shedding by firms is too aggressive, then consumer optimism may suffer as a result.

The inventory to sales ratio, after undergoing an aberrant increase due to the impact of the September 11 events, is again trending down. However, security considerations that have arisen since the terrorist attacks may necessitate somewhat higher inventory levels in some industrial sectors. This may be required for precautionary reasons, so that production is not held up in the event that suppliers cannot send parts quickly under a finely tuned just-in-time model. Meanwhile, the index of leading economic indicators is edging up again, pointing to a turnaround in the economy.

Consumer inflation poses no risk in the near to medium term. Oil prices remain low, with little chance of an upward move. Wage rates are moderate, in the face of tough labour market conditions. Corporate pricing power is weak and, despite moderation in wages, this has caused a margin squeeze that has resulted in low profitability. So the near-term outlook is for lower inflation. However, there are reasons why the longer-term outlook may not be quite as rosy for those investing in long-dated bonds. If the productivity growth rate turns out to be lower than in recent years then as the economy heats up price increases are likely to arrive sooner rather than later. In addition, projected higher federal government budget deficits will impose demands on resources and loanable funds.

At the beginning of 2002, the fed-funds rate stands at a historically low level, and with signs of an economic turnaround in the first quarter there is little need to reduce the target rate again. Consumers have been helped significantly via mortgage refinancing, but also in the availability of cheaper loans to finance spending. Zero-interest-rate financing offered by auto companies, last year, was an instance of that. More generally, credit conditions are a lot looser than they have been in previous difficult economic circumstances. The Fed is likely to maintain low rates well into the year, with the possibility of minor increases in the latter half of 2002.

The Treasury yield curve started 2001 with a semi-inverted shape. After a series of interest rate cuts by the Fed the short end of the curve was pushed firmly lower, giving it a positive slope that has now steepened further, out to ten years. Meanwhile, high-grade corporate bonds have attracted investor interest and should continue to do so in an improving economic environment. The search for greater yield has also enticed a lot of money into high-yield bonds, which have already seen rising prices. They may still offer some opportunities, although volatility is likely to remain high.

The S&P 500 index, after swooning in September, rose sharply in the last three months of 2001. Investors’ renewed interest in technology stocks contributed significantly to the upward move. Some bears were caught napping and had to cover their short positions. At the same time, momentum players got into the act, and fund managers, ever fearful of being left behind in a potentially strong rally and holding a lot of low-yielding cash, were strongly motivated to commit to the market. Earnings growth expectations remain quite optimistic and, if not confirmed by subsequent reported results, this could challenge current valuations. Needless to say, in historical terms, the index is at a relatively elevated level, for this stage of the business cycle. As a broad measure, the P/E ratio, both on a trailing and a forward-looking basis, is quite high. Even with the technology sector removed from the index valuations are not particularly cheap. Returns to equities in 2002 will be determined more by selective investment decisions than by indexing.

The worst-performing major stock market index in 2001 was the Nikkei 225, because of the sorry state of the Japanese economy and yen weakness. Foreign investors often experienced disappointment after thinking that they had finally seen the bottom of the market. Investing in Japanese equities will remain a challenging task. Some of the best-performing stock markets in 2001 were in emerging markets, and this is likely to be repeated in 2002. The Nasdaq composite index recouped some of its losses in the final months of last year as technology stocks returned to favour. Sustaining and building on the gains, into this year, will be a challenge.

The dollar has racked up solid gains against most major trading currencies, and given economic weakness in most regions, it is not about to fall rapidly from its perch. The Eurozone’s growth rate and dynamism are not yet convincing enough to cause large portfolio reallocations from the dollar. With a quietening of international political tensions, in the anti-terrorism campaign, the role of the Swiss franc as a safe-haven currency is somewhat diminished.

The Eurozone economy will just skirt recession, and the rebound this year is unlikely to be vigorous. Strength in the latter half of the year will depend on how well the U.S. economy performs, by generating export demand. Fiscal deficits will worsen, in the major countries, as a fall-off in activity reduces tax receipts and a rise in unemployment pushes expenditure higher. Low capacity utilisation rates and a deterioration of corporate financial positions, along with lower profit margins, will mean that capital expenditures will be weak. Inflation is expected to drop, and this should result in stronger consumer spending despite higher unemployment.

The economic outlook in Japan is quite bleak, and risks to the financial system have increased. However, there is no recognition among policymakers that there is an urgent need to act. It is difficult to escape the conclusion that unless a crisis situation actually develops decisive action is unlikely to ensue. A good policy stance would involve more aggressive quantitative easing by the Bank of Japan, to instil inflationary expectations among the public. This could be accompanied by a better-targeted fiscal policy, more effectively implemented restructuring measures and a weaker currency. The Japanese economy will continue to be in recession in the first half of this year, returning to modest growth in the latter half, on the back of an upswing in the global economy. Unemployment will rise, capital expenditure will contract and consumer spending will fall.