In May, the combination of strong global equity markets and low volatility that had endured for three years came to an abrupt halt. With nervousness in financial markets continuing, it pays to take a step back and consider the performance of the equity markets in the context of the last 18 months.
The markets that went up most in 2005 have suffered the biggest peak-to-trough correction this year. And although higher-risk assets such as emerging market equities fell most from their peak (by 24%), safe-haven assets like gold declined almost as much (22%) and yet lower-quality corporate credits barely wobbled. Now most regions have recovered sufficiently from their lows to bring year-to-date performance close to the flat line.
Globally, what triggered the sell-off was the recent acceleration in US core inflation above the Federal Reserve’s “comfort zone”. In just a few weeks, investor expectations have shifted from a “pause” on interest rates to a widespread view that there will another 25 basis point increase in August.
But the relatively stiff fall in Japanese equity prices in the sell-off was a result of country-specific factors. Since the beginning of the new fiscal year in April, the Bank of Japan has been aggressively draining liquidity, with the end of its policy of “quantitative easing”. In short order, base money contracted by 15% year on year.
Also the run-up in Japanese equities from September 2005 to March 2006 coincided with record levels of margin buying by individuals. The Nikkei’s subsequent drop expressed the clearing out of this speculative fever – the market had simply gone too far too quickly.
The sell-off was also exacerbated by the scandal surrounding Bank of Japan governor Toshihiko Fukui over his ownership of shares in an investment fund, whose manager has been accused of insider trading. Fears of a US economic slowdown also played a role. All these factors made the Nikkei more prone to an outsized correction.
Still more to be priced in
Nevertheless, despite its strong performance during 2005, the Japanese equity market has yet to reflect fully improving corporate fundamentals. Since the beginning of fiscal 2001, corporate sales are up 13%, profits have soared 90% and yet the Nikkei is still down 22%.
The economy as a whole continues to improve. In the first quarter of 2006, Japan expanded by 3.5% year on year, increasingly driven by domestic demand and supported by job creation and wages growth. More than half a million jobs have been created so far this year. Banks continue to increase lending, particularly to the fast-recovering property sector. And deflation is over.
| Germans get more confident |
| IFO (lagged five months) and eurozone earnings per share growth |
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| Source: Datastream |
Like markets in Japan, those in the eurozone suffered relatively heavy losses during the recent equity sell-off. They too had outperformed the US over the past three years. Now investors fear that the European Central Bank could increase interest rates excessively and so crowd out economic growth and corporate profitability.
But I reckon the economic momentum will be sufficient to sustain expansion. Fundamentals in the eurozone remain sound. In Germany, consumer confidence is rising fast, retail sales are recovering and profits and entrepreneurial income as a share of national income has soared. Eurozone bank lending to households, particularly for property, is accelerating.
Over the past 15 years there has been a strong correlation between the German IFO business confidence index and the outlook for eurozone earnings growth. Indeed, the typical five-month lag between the earnings cycle and business confidence means that eurozone profit growth is likely to accelerate over the summer months. Ironically, with unemployment still relatively high in the eurozone, it will be easier for companies there to keep labour costs down than it will be for those in the US.
The politicians are unlikely to make things any worse for the business sector. Indeed, in Germany, the coalition government is pledged to cut payroll taxes to help corporate profitability. Chancellor Angela Merkel is now pushing hard for the coalition to agree on longer-term reforms (a cut in corporation tax, pruning health spending and the devolution of more government spending to the regions).
Eurozone equities are cheap on most measures compared with US ones. And Japanese equity valuations are exceptionally attractive in the light of their own history. So I reckon Japan and Europe will outperform the US in any equity rally. Or, if the long, slow grind down continues, they will prove defensive markets in any portfolio versus US and emerging market equities.
David Roche is president of Independent Strategy Ltd, a London-based research firm.www.instrategy.com