Equity markets look set to continue climbing

INVESTOR/An Insider's Guide to the Market: The global equity market rally that began in April continued during the traditionally quiet holiday month of August.

The gains were not as strong as in some previous months. Returns, nonetheless, were healthy with the bellwether Standard & Poors 500 index posting a positive return of 2.8 per cent and the ISEQ Overall index an even better monthly return of 3.9 per cent.

A glance at the accompanying table showing year-to-date equity returns confirms that 2003 is now almost certain to be the first year since 1999 that exhibits broad-based positive returns from equity markets.

Indeed, if equity markets can continue to advance from now to year-end, 2003 will turn out to be an exceptional year for equity markets. This would represent a dramatic turnaround from the gloom and near panic that gripped equity markets during the first quarter of 2003.

While the rise in global share prices has been broad based, there are large differences in returns between the three major global economic blocs. The US has led the global rally where the S&P 500 index is now up 14.6 per cent so far this year. The rise in the technology-laden Nasdaq Composite is more than double this at 35.6 per cent.

Given the inherently volatile characteristics of Nasdaq stocks this relative performance is not too surprising. However, it does heighten worries that at least some of the rise in stocks over the past six months is highly speculative and could be easily undone.

On average, European equities have lagged American stocks so far this year. The rise in the major European equity markets looks pedestrian when compared with those in the US. The FTSE Eurotop 300 index, which includes Europe's largest quoted companies, rose by a modest 5.3 per cent in the first eight months of the year. In Britain, the FTSE 100 did marginally better with a rise of 5.6 per cent.

The rise in the ISEQ Overall index of 15 per cent is much better than the European average and is marginally ahead of the rise in the S&P 500. But if returns are expressed in common currency the gap between Europe and the US narrows appreciably.

Despite the recent pullback in the value of the euro to a €/$ rate of 1.0984 at end-August, it is still about 5 per cent higher than the rate of 1.0494 at end-December 2002. Therefore, the dollar return of 14.6 per cent from the S&P 500 falls to approximately 10 per cent when translated into a euro-denominated return. Making the currency adjustment highlights that the Irish equity market has delivered an exceptionally good return for investors.

Another notable feature of the figures in the table is that equity markets in the Far East have enjoyed strong returns. The long decline in the Japanese equity market has been at least interrupted with the rise of 23.1 per cent. Even allowing for the 3 per cent decline in the yen/euro exchange rate, it is clear that equity investors in Japan enjoyed a much-needed respite over the first eight months of the year.

With regard to US and European equity markets, there is general consensus that the recovery in share prices since the March lows is for real. The worst equity bear market since 1972-73 is now considered to be over, although there is intense debate as to the sustainability and underlying strength of this new bull market.

The argument supporting a prolonged bull market is that the global economy is at a turning point and that a cyclical economic recovery is probably already under way. Cumulative economic data from the US already confirms that a cyclical recovery has begun and is gathering strength.

The Japanese economy has also recently surprised on the upside and only the euro-zone economy has yet to exhibit clear signs of recovery. However, if the euro zone can begin to grow by year-end, the stage would be set for synchronised global economic growth in 2004 and beyond.

In such a scenario corporate earnings would be growing strongly, and crucially this growth would be occurring in an environment of low inflation and low interest rates. Share prices should continue to appreciate.

The main arguments pointing to a more cautious view of share prices are twofold: first, the key measures of value in equity markets indicate that share prices are still fundamentally overvalued despite the price falls over the 2000-02 period; second, there are several financial imbalances across the world's financial system that are causing concern.

With regard to the latter, the areas of concern include the large and growing US fiscal and trade deficits and the high level of indebtedness among individuals, particularly in the US.

A further worry is that the appreciation in house prices across many countries in recent years may well be another asset price bubble that could burst. Most policymakers and analysts agree that a large decline in house prices would have a much greater impact on the real economy than an equivalent decline in share prices.

On balance the short-term positives associated with an emerging cyclical recovery are likely to outweigh these longer-term concerns thus underpinning global equity markets.