Not much joy for equity investors

USA
The allegation of accounting fraud at WorldCom dealt another blow to investor confidence that has already been shattered by profit concerns, warnings about terrorist attacks and tensions in the Middle East.

Consensus expectations for 2Q profits have dwindled, down to a negative 0.2% on average year-on-year for the S&P 500 from last month's 1.2%. A recent poll of investor attitudes, falling sharply in June to its second lowest level in its history, showed that only 38% of investors were optimistic about the prospects for the financial markets over the next 12 months, dropping from 46% in May.

However, the economy offers bright hope, reinforcing our belief that the stock market will eventually return to its recovery path. The economy grew 6.1% for 1Q, and the consensus expects 3.5% GDP growth for 2H. Despite slower consumer spending in 2Q to a 2.5% rate, chain-store sales rebounded strongly during June, setting the stage for a stronger 3Q while mortgage refinancing accelerated, supporting consumer spending.

The ongoing strength of housing activity should precede an increase in the demand for home goods. Also, the fall in jobless claims to 388k, the fourth consecutive week below 400k, together with the expected pick-up in job growth, suggests that spending risks in 2H are probably to the upside. Capital spending finally turns up as new orders for capital goods jumped by 3.3% for May after rising by 1.4% for April. Tech orders rose for the third consecutive month, up 1% for May after jumping by 2.9% for April.

Finally, the Federal Reserve is unlikely to hike rate until probably in the November FOMC meeting when the recovery is firmly on track. Technically, the stock market's resilience in the wake of the WorldCom debacle suggests that it may be nearing a bottom and a potential rally is forthcoming.


Japan

The 12% drop of the TOPIX between the end of May and June 26 was because of a convergence of factors. Firstly, 47% of Japanese institutions were overweight their benchmarks in domestic equities, as a result of having increased their holdings during market weakness in January and February and the subsequent rally in the market.

Shares were sold to reduce their exposure - in May and June, trust banks alone sold Y445 bn of equities. Secondly, investors were disappointed by the government's anti-deflation plan announced on June 21 and the interim report on reform of the tax system. Thirdly, fears increased of a Middle East war or renewed terrorist attacks. Fourthly, the yen strengthened from Y125 to over Y120 to the dollar over the month, causing worries about the durability of the export-led recovery and the knocking stocks of exporters.

Finally, weakness in the U.S. market finally caught up with the Tokyo market. The Nikkei Average rallied strongly late in the week as gains on Wall Street and better-than-expected industrial output data at home triggered buying in technology shares. Japan's industrial production rose 3.9% in May, topping forecasts.

With Japanese valuations at record low levels and the cyclical recovery still on track, there is a chance that the Japanese market could decouple from the U.S. Price-to-book and price-to-cash flow measures are the two valuation metrics that have statistical validity. Price-to-book shows Japan is close to an all-time low, the cheapest when compared with the U.S. (higher than at any time prior to 1997) and Europe (slightly higher than in the 1984-1996 period).

Price-to-cash flow shows that the market is back almost to an all-time low of 10.0x (average 13x), compared to 15.1x in the U.S. (average since 1984 is 10.5x) and 10.6x in Europe (average is 8.0x). Besides the positive valuation backdrop, the direction of the economy, with more upside potential than downside risk, is expected to push the market up. However, systemic risks coming from the U.S. may put a lid on the rise.


Europe

European stock markets rallied sharply the end of the week to close in positive territory after financial stocks recovered and Wall Street extended gains in spite of fresh concerns about corporate accounting irregularities.

The main indices once dropped below their September 21 intraday lows on Wednesday after WorldCom revealed a $3.8bn deficit in its accounts. European semiconductor stocks rebounded on analyst's upgrade of the sector. Shares of STMicroelectronics, Infineon and ASM Lithography jumped. Banks were generally firm as investors put aside concerns about their possible exposure to WorldCom.

Oil stocks got a moderate boost from Opec's decision to leave tough output limits for another three months. We continue to forecast a healthy industrial recovery in Europe as the bottom for industrial production was already seen. Base effects will result in strong year-on-year growth rates for next year, despite a weak U.S. dollar that will dampen the consumer-facing export sector more than the industrial cyclicals.

Postponement of rate hikes will benefit the latter. HSBC has reduced its earnings forecasts only slightly to 5% this year (both including and excluding financials) and 14% next (16% excluding financials). Market ex TMT appears reasonably valued and, at only 13% of the European market, TMT's ability to drag the index down is beginning to weaken.

Asia ex Japan

Selling pressure dominated Asian shares on Wednesday, driven by news of a $3.8 billion accounting fraud at WorldCom and Micron Technology's unexpected losses. However, Asian fundamentals remain relatively intact as the region's aspects of growth, valuations and liquidity ensure its relative outperformance.

In Korea, technology shares partially recovered on better market sentiment underpinned by the government's latest effort to boost the country's stock prices. The Finance Ministry on Thursday said it would urge the National Pension Fund to bring forward 600 billion won in stock investments the fund has earmarked for this year. Meanwhile, Fitch Ratings raised South Korea's long-term foreign currency rating two notches to A from BBB+, citing the country's reform efforts and strong macroeconomic performance.

In Taiwan, stocks fell on continued weakness in leading technology shares. Export-oriented technology shares were under pressure as investors feared that the strength of the local currency would erode such companies' overseas earnings. The New Taiwan dollar rallied to a fresh 13-month high against the U.S. dollar.

A newspaper cited that at this currency level some high-technology hardware manufacturers, including personal computer and motherboard makers, would face foreign exchange losses for 2Q. The Taiwan Weighted Index dropped to the lowest close since early December last year despite a 25 bps rate cut from the central bank on Thursday, bringing interest rate to a record low of 1.875%.

In Hong Kong, investors dumped shares of the railway operator and property developer MTR after the company lost out to rival Kowloon-Canton Railway for a HK$31 billion contract to build cross-harbor rail link. Hutchison Whampoa dropped as investors shrug off the company's announcement that its Irish subsidiary has won a third-generation mobile telecoms spectrum license in Ireland. Exporters also sank on concerns that a delayed recovery in the U.S. would hurt their profits. Consumer products trader Li & Fung and electrical equipment maker Johnson Electric dropped. Bargain hunters returned on Thursday to build positions in anticipation of better economic conditions in 2H, helping the index to close unchanged for the week.