Promising signs but early recovery is not certain

Despite the economic gloom that has taken hold following the terrorist attacks on September 11th, US equity markets have been sending a very strong signal that economic recovery is on the distant or perhaps not-too-distant horizon.

Naturally, European markets are following the lead of the US and are ignoring an economic bloc that is still playing catch up with the US in terms of deteriorating economic conditions.

The predictive qualities of equity markets need to be treated with caution as they have only a modest track record in predicting economic turning points. However, the performance of markets since the collapse that immediately followed the US attacks is giving optimists on the US economic outlook plenty of fodder.

Since the beginning of October, the S&P 500 has posted gains of more than 10 per cent and the technology-laden Nasdaq has put on more than 27 per cent. These gains occurred despite a stream of mostly poor economic data and only limited positive guidance from the US corporate sector.

The gains in the tech sector are stunning and valuations in some areas are almost as demanding as those achieved in spring 2000, just before the bubble burst.

Equity investors have a habit of ignoring bad news at the moment and the largest intra-day gains in the current rally have been made on days that have seen the release of particularly poor economic data. Investors are very mindful of history, which shows equity markets usually rebound before the bottom of recessions are reached and while corporate earnings are still falling. This is certainly the case at the moment.

Also, there is precedent to suggest that, in the 24 months following the trough in the markets, 50 per cent of market gains are achieved in the first six months.

Investors are very aware of these facts at the moment and are nervous about missing the bulk of the rally.

For fund managers, who have taken a battering over the past 18 months, being out of the markets at the moment is more dangerous than being fully invested. Hence money is currently being put to work in a gradual but market-supportive basis.

However, there is more than history driving the rally. During the summer, the markets were difficult and this looked set to continue unless some event sparked capitulation.

The event arrived in the shape of September 11th. Markets immediately panicked and prices fell sharply as economic gloom descended. However, having attained painful lows on September 21st, the markets started to rebound strongly and it has developed into a strong rally.

This rebound was driven initially by a realisation that valuations achieved on the 21st were ridiculously cheap, but later by a belief that, although the economic downturn would be sharper, the eventual rebound would be stronger as a result of the very aggressive official policy response precipitated by the crisis.

US interest rates have fallen to much lower levels than anybody believed possible before September 11th, and the fiscal boost has been much greater. Liquidity conditions have improved and hopes for a V-shaped economic recovery have grown. Furthermore, bond yields have started to edge up in recent days, suggesting that bond markets are starting to tell the same economic recovery story as equity markets.

There are undoubtedly risks to equity recovery in the shape of economic factors and emerging signs of irrational exuberance. The US labour market is still telling a pretty poor story, a factor that will be important for consumer dynamics going forward.

The key weakness in the economy is the manufacturing sector, where jobs continue to be shed and output fell by a massive 1.1 per cent in October, the 13th consecutive month of decline. However, the 7.1 per cent jump in retail sales in October, although primarily driven by a zero-finance induced surge of 26.4 per cent in car sales, is giving some grounds for confidence that the consumer might just be recovering from the shocking events of recent months.

Further grounds for optimism were provided this week by the 0.3 per cent jump in the index of leading indicators, with components such as slower delivery times suggesting demand may be picking up and consumer expectations may be rising. The manner in which the war in Afghanistan has progressed and the reduced likelihood of further terrorist attacks will strengthen the belief in a consumer recovery.

However, it is important to remember the global background is still extremely weak and will test the resilience of markets over the coming months. The trade data released in the US this week show that global trade continues to shrink.

The irrational exuberance refers to the performance of certain components of the TMT sector, whose valuations may once again be difficult to justify on the basis of likely earnings growth in 2002.

The US background is still terribly uncertain and, while there are encouraging signs, there is no guarantee that stabilisation will be followed by an early and robust recovery. The OECD has forecast US growth of just 0.7 per cent in 2002, but a strong 3.8 per cent performance in 2003.

Such an economic prognosis, if delivered, should be sufficient to keep equity investors in buying mode but, as Isaac Newton once said: "I can calculate the motion of heavenly bodies but not the madness of people."

Jim Power is chief economist at Friends First Holdings