The pattern of returns from global equity markets during the first half of 2001 has resembled a rollercoaster ride and many investors in the markets must be wishing that they got off the rollercoaster at the start of this year.
While much of the volatility was concentrated in the technology, media and telecoms (TMT) sectors, many "old economy" sectors also experienced above average share price volatility over the past six months.
All of the downside damage to share prices occurred during the first quarter, as is clearly illustrated in Table 2. All major stock market indices fell, with the largest fall occurring in the technology-laden Nasdaq index, which declined by more than 25 per cent during the first quarter.
Quarter 2 witnessed an erratic bounce back in share values. Nevertheless, with the notable exception of the ISEQ, the vast majority of global stock market indices are showing large negative returns over the first half of the year.
The dominant influence on stock markets during the first six months of 2001 has been the relentless stream of corporate profit downgrades. Evidence of declining corporate profits first emerged in the TMT sectors in the US. Chief executives of many of the world's largest technology companies seemed to be taken completely by surprise with a sudden fall-off in demand for their products. Companies that produce high value capital goods, such as Lucent Technologies in the US and Marconi in Britain, have been particularly hard hit. There seems to be a domino effect rapidly working through the entire TMT sector. The emergence of large-scale debt burdens among the telecoms companies has forced them to cut back on capital spending. This has fed through to falling demand for computer and other hardware equipment. Delays in introducing new technologies in the mobile phone sector have meant that mobile phone producers such as Nokia have had to scale back their estimates of growth in demand for handsets.
The slowdown has also fed through to the producers of software, a sector that has witnessed some of the most dramatic share price declines. This reflects the fact that many software companies are single product companies and have to spend heavily on research & development before their products become profitable. Baltimore Technologies represents a dramatic example of just how operationally and financially geared many of these companies are, thereby making them hypersensitive to any downturn in demand.
During the second quarter, analysts in the US began to take the view that the second half of the year would be better than the first. To a large extent this sanguine assessment was based on the alacrity with which the US central bank, the Federal Reserve, reduced US interest rates. After surprising the market in January with an interest rate cut, the Fed continued to surprise during the second quarter.
On April 18th, outside of its regular monthly meeting, the Fed sprung a surprise intermeeting cut from 5 per cent to 4.5 per cent in its key Federal Funds rate. On May 15th, a further cut to 4 per cent was announced and finally, on June 27th, the Fed cut another quarter point to 3.75 per cent.
Normally, interest rate cuts have a positive impact on economic activity with a lag of about six to eight months. Therefore, the optimists take the view that low US interest rates will begin to have a positive impact on demand within the US economy by the fourth quarter of 2001 at the latest.
Unfortunately, there are several reasons for continuing to be cautious about the prospects for the global economy and hence equity markets for the second half of the year. An unusual feature of the current global economic slowdown is that it has been entirely driven by a sudden and sharp fall-off in investment demand. Excluding the government sector, demand within an economy can be classified as either consumption (C) or investment (I).
Consumption accounts for a much higher proportion of demand but investment is much more volatile. After years of huge increases in investment spending, particularly in computer hardware and software, American business has suddenly stopped spending on investment equipment.
Capital spending during the boom years has been so large that American businesses now have too much capacity for the near-term level of demand for their goods and services. To the extent that this is the case, interest-rate cuts will fail miserably in acting to stimulate investment spending. Put simply, US companies now have more than enough computers and enough software and therefore will not buy any more equipment no matter how low interest rates fall.
Demand for capital goods will only rise when enough of the existing capital stock becomes obsolete.
On the other hand, US consumer demand has held up remarkably well so far and interest-rate cuts could well succeed in preventing a collapse in consumption. Job losses and declining real wealth due to falling share prices have certainly acted to puncture US consumer confidence. However, the easy money policy of the Fed may be sufficient to underpin consumer confidence, thereby averting an outright US recession.
While the prospects for the US economy in the second half of the year are finely balanced, the situation in Europe seems set to deteriorate. In recent weeks high-profile profit warnings from companies such as Marconi in Britain have rocked the markets. The really worrying feature is that the accompanying statements cited a sharp fall-off in investment demand across Europe as the main culprit.
With the European Central Bank much slower to cut interest rates than the Fed, the prognosis would seem to be that European economic growth will progressively slow through the second half of 2001.
The sectoral performance of stock markets has been largely influenced by the nature of the current global slowdown, namely the sharp fall-off in investment spending. Companies in the capital goods-producing sectors of the market have suffered the sharpest price declines. In contrast, companies that depend on consumer demand have performed much better.
Table 3 provides some summary data for the US, Europe and Ireland that illustrate this. Technology stocks have been hardest hit, while bank share prices have held up very well. European pharmaceuticals have outperformed sharply, although the US sector did have a poor year-to-date performance. In part, this represented profit-taking after a very strong performance in 2000. In Ireland, the pharmaceutical sector is dominated by Elan, which produced another stellar performance over the past six months.
Table 1 shows the 10 best and worst year-to-date performers in the Irish market. Given that the NASDAQ is the main market for most of the Irish high-technology companies, the performances are based on the local currency performances.
For example, the return of -47.9 per cent for Iona Technologies is in dollar terms and the decline in euros would be even greater given the weakness in the E /$ rate. Companies in the food, financial and pharmaceutical sectors dominate the top-performing shares. The only "new economy" stock to make the top 10 list is Riverdeep Group. In contrast, the 10 worst performing list is almost entirely made up of "new economy" stocks which have suffered enormous declines in value.
Baltimore is now worth only 5 per cent of its value at the beginning of the year, while Horizon and Trintech are only worth 20 per cent of their respective opening year values. The only "old economy" companies to be included in the under-performers were Unidare, Dunloe Ewart and Independent News & Media. In the case of the latter, its poor share price performance is almost entirely due to its exposure to some new joint ventures in the high-tech arena.
The prospects for the second half of the year continue to look very uncertain and while crystal-ball gazing with respect to the financial markets is a futile exercise, a period of continued above average volatility seems to be in prospect. It is difficult to envisage further share price declines in the TMT sectors of the same order of magnitude as was experienced in the first half. However, a meaningful rebound in the share prices of these companies seems even more unlikely. Much will therefore depend on how the "old economy" sectors of the markets perform and this will be a function of how the global economy performs.
Current share prices probably reflect the consensus view that the US economy will be recovering by the fourth quarter and that European growth will only decline modestly. If the economic outcome turns out to be worse than this consensus then a further round of corporate profit warnings will unfold. As far as the stock markets are concerned it could yet be a long hot summer.
