INVESTOR: With recovery now under way and global markets beginning to perk up, a crucial determinant of share prices will be the response of central bankers to improving economic trends.
Recent comments from Mr Alan Greenspan, chairman of the US Federal Reserve (Fed) strongly support the view that the US economy has already emerged from the 2001 recession. Indeed, economic data for Quarter 4 indicate that the recession was in fact far shallower than most analysts had previously estimated.
The debate has now moved onto the issue of whether the upturn will prove to be strong and sustained or weak and faltering. Equity markets have already begun to respond to the whiff of economic recovery and the early days of March have witnessed a strong and extensive rebound in equity prices.
Broad-based indices such as the S&P 500 and the FTSE Eurotop 300 had risen by more than 6 per cent in the first week of March. In the Far East, the seemingly endless drop in Japanese share prices was reversed with a 22.7 per cent jump in the Nikkei 225 index.
Technical factors and official support for the market seemed to have played a big part in this recent bounce in the Nikkei. End-March is the year-end for the majority of Japanese financial institutions and the solvency of the entire banking system benefits from higher share prices at this time of year.
Although there are many reasons to be sceptical about the sustainability of the bounce in the Japanese market, the same is not true for US and European markets. The March recovery in share prices does seem to be due to a genuine improvement in underlying economic conditions. The extent of these gains has already been sufficient to push most of the major stock market indices into positive territory in the year-to-date.
The ISEQ is an exception to this primarily because of the collapse in the Elan share price. This is evident from the fact that the ISEQ Financial index has risen by 3.6 per cent so far in 2002 compared with a decline of 20.5 per cent in the ISEQ General index.
A key factor in stimulating the recovery has been the low interest-rate regime engineered by central bankers. In particular, the Fed moved early and often to bring US interest rates down to their current level of 1.75 per cent.
Despite the criticisms levelled at the European Central Bank (ECB) for being unresponsive to the needs of the economy, it can be seen that euro-zone rates are also quite low. Euro interest rates are not as low as US interest rates but they are significantly lower than sterling rates.
Given that the European economy did not experience as sharp a slowdown as the US, the policy adopted by the ECB seems justified. Low interest rates and economic growth represent the ideal environment for equity markets.
At face value, therefore, if economic growth does continue to pick up, the recent recovery in share prices could well represent the beginning of the end of two years of weakness in global equity markets.
Economic forecasters are now predicting economic growth of 3 per cent per annum in the US this year and there are some signs of improvement in the euro zone.
The European economic cycle seems to be following the US with a lag of about six months, so that stronger European growth in the second half of the year now seems likely.
Given that Europe did not slow down as much as the US economy, it is likely that the European upswing will be weaker than that of the US.
A crucial determinant of share prices will be the response of central bankers to these improving economic trends. In Europe the style of the ECB is to make infrequent changes to interest rates, which suggests that the ECB will hold rates at current levels for some time.
Up to recently the ECB was under pressure to make one further cut in rates. If growth does pick up then this pressure will quickly dissipate and the bank will be vindicated in its recent policy stance. In contrast, with US interest rates well below European rates, a change in stance by the Fed now seems inevitable. A recent survey by Bloomberg of Wall Street's biggest bond dealers showed that these dealers now expect the Fed to adopt a neutral stance at its March 19th meeting.
This would be a prelude to increasing interest rates at a subsequent meeting, although a significant minority of bond dealers felt that the Fed could actually raise interest rates as soon as March 19th.
Given that US interest rates will be rising from such a low base, equity markets should be capable of absorbing initial rate rises up to about the 3 per cent level with ease. However, if the Fed were to signal a more aggressive pace of rate rises, then this would limit the upside.
Now that the US economy seems to have turned the corner, the focus of attention in coming months will be skewed towards evaluating any changes to the monetary stance adopted by the world's most powerful central bank.
