Some thoughts following the attack on the US
Following the tragic events of 11th September, we have the following thoughts regarding the US and global economy and financial markets.
The impact on the US economy could be severe, as the economy is already on the brink of recession. We had previously hoped that consumer spending, which accounts for two thirds of overall GDP, would remain relatively insulated whilst corporate investment underwent a cyclical correction. This now seems unlikely, and we anticipate falling household consumption will drag the overall economy into recession. Airlines, travel, and hotels -which account for approximately 10% of US GDP- are likely to lead the downturn in the consumer sector. Retail sales will be depressed for the remainder of the year. In the longer term there will be new security costs, particularly for the travel sector and for high profile corporates. The cost of doing business will probably rise more generally, putting further pressure on profit margins.
Prior to the attack we had been anticipating further interest rate cuts by the Fed; they have already promised a further injection of liquidity into the financial markets, and we now expect a further and faster fall in interest rates than was previously expected. The Bank of Japan and the ECB have already responded by injecting liquidity, and it is likely that monetary authorities around the world will work to ensure that financial markets remain liquid.
On the financial markets, we expect short-term out performance from government bonds as the risk premiums on equities and corporate debt rise. Longer term, there must be concern that the injection of liquidity that we are expecting will generate inflationary fears, which in turn may lead to a rise in bond yields during 2002.
We believe that US equities will start to price in a recession, and the risk premium will rise further. But bearing in mind the extent of share price falls prior to the attack, it is possible that we are closer to the bottom of the cycle than we realise. Economic recovery in the US has been postponed, but by months not by quarters. We expect to see selective stock picking to take place on Wall Street in the meantime.
The magnitude of any immediate fall on Wall Street will clearly influence the extent of further weakness on other major stock markets; meanwhile weaker US consumption will result in increased pain for European and Asian exporters.
Several stockmarket sectors are immediately affected, all of them negatively. We have already mentioned consumer stocks; on a general note conspicuous consumption will probably become unfashionable and -with a negative wealth effect from the stock markets- unaffordable. Oil stocks made an immediate gain after the attack, as the price of crude jumped. However, without a major disruption to supply, the higher oil price appears to be unsustainable, given that global demand is likely to fall.
Therefore, despite the relatively cheap valuations of oil stocks, they may soon come under some selling pressure. First estimates for the insurance industry are of US$40 - US$50 billion of liabilities caused by the attacks, roughly equivalent to the fall in market capitalisation of the sector in the hours after the attack. Banks -both retail and investment- will be affected by the slowdown in business activity, and the rise in bad debt that accompanies a recession.
How does this affect our global portfolios? We were already in a defensive mode prior to the attack, with generally flat portfolios relative to their benchmarks. We do have underweight positions in consumer cyclical stocks, and overweight positions in oils. We do not intend to alter that approach until we receive more information. Volatility will give rise to buying opportunities, and we may increase exposure to genuine growth companies that appear oversold in sectors such as services and possibly technology.
Japan is a worry. Its banking system was already in a state of near crisis on account of the large amount of bad debt it is carrying, and the falling value of the shares that the banks hold in their balance sheets. A collapse in demand from its largest trading partner, the US, would weaken the depressed economy, and the financial system, still further. It would also make it harder for the government to implement much needed economic reform, on which so much depends.
Finally a word on currencies. The dollar is usually a safe haven during crises such as this. But with a domestic recession looming, and the prospect of further rate cuts by the Fed, the Euro is likely to gain against the greenback. The yen will probably be relatively weak.
What of the longer term implications? Much will depend on the nature of the response of the US. But, assuming it is not disproportionate, the terrorist attack on the US is likely to be recorded in economic history as the trigger that sent an already weak economy into recession. Economic and stock market recovery, however, should follow and now is not the time to sell equities.
Martin Porter
Chief Investment Officer
