Macro-economic worries have taken their toll as drivers of equity prices, despite robust corporate results and healthy M&A activity. Uncertainty over future monetary policy action and the inflation outlook, amid rising commodity prices, have dominated investor sentiment, and market activity reflects these concerns. On the positive side, the market remains susceptible to short-term rallies on hopes that economic growth in the emerging world would be sufficiently robust to compensate for a slowdown in the US and possibly other developed economies.
We suspect a combination of aggressive action by central bank and increasingly attractive valuations could provide a floor for European equity markets in the next three to six months. There have been 15 Federal Reserve rate cuts of 75 basis points or more since 1970, and the average six-month performance of the MSCI Europe after these cuts has been 10.3 per cent.
The real concern is whether inflation will prevent central banks from being aggressive in cutting rates. There is still a risk that a substantial deterioration in the US growth outlook, an earnings recession, lower commodity prices and more de-leveraging could lead to new lows for share prices. Then the markets might trade sideways for the next few years.
In 2008, we are likely to see a continuation of the market volatility seen in second-half 2007, as the impact of slowing economic growth and rising inflation come through in earnings expectations. The developed economies will slow down in the near term, the extent of which will determine companies’ profitability and balance sheet strength going forward. In a recession earnings go backwards and markets fall. But the fall in markets is the discounting process of lower growth; once the markets look through the reduction in profitability, recovery usually follows. In fact, performance through a whole recessionary cycle is not necessarily negative. Moreover, we expect robust growth in emerging economies, driven by stellar performance in Asian countries. This will provide support to European companies with exposure to these economies. In the near term we prefer large-caps and defensive sectors, and believe earnings stability is a key factor in stock picking.
Rick Lacaille, head of international active equities, State Street Global Advisors.
