Looking beyond the rate cuts

Global equity markets have been slow to react to aggressive rate cuts but Chris Selth says it is too early to dismiss the significance of these moves. He says a more resilient Asia, some interesting trends and the digestion of technology spend could see the market perform more strongly.

Equity markets haven't behaved as many market observers may have expected recently. For instance, you may look at Greenspan's frenetic spate of interest rate cuts and wonder why equity markets haven't bounced more strongly.

You might also wonder why Asia didn't just go into meltdown last year when things went astray in the US, or look at Europe and question its stubborn bottoming phase. You might also believe that, after innumerable false starts, Japan is in fact a perpetual basket case, and the bear is with us for some time to come.

But the surface masks some strong undercurrents, particularly now that equity markets are starting to trade in a more limited range.

Indeed many people would have expected international equity markets to come back a little stronger than what they have done, given that markets generally look forward, and Greenspan has offered plenty of stimulus. But this assumption doesn't take into account the lightning speed with which this easing cycle has occurred.

When comparing the recent cuts to past easing cycles, the key difference is the period of time over which the cycle has taken place. Previously we were looking at 12-18 month cycles, and equity markets have bounced towards the end of the cycle, when the economy picked up and corporate earnings had more certainty.

This time however we have seen five interest rate cuts within six months. The economy has yet to digest the cuts, and earnings are yet to show signs of recovery. We are in digestion mode.

A very interesting thing to come out of the last year's US deterioration was the resilience in Asia. Usually you have a kind of leverage situation, where Asia would react in multiples to large movements in the US.

But this just didn't happen last year. From April to December 2000 the S&P was down 11.9 per cent, while Hong Kong's Hang Seng, for instance, was only down 13.3 per cent. In part this is due to the large amount of restructuring that has occurred in Asia, meaning the blue chips have become more sound businesses.

It is also the result of a profound shift in the composition of power in Asia. In the past when you were talking about the Asian tigers you were talking about Thailand and Indonesia. The real Asian story now is North Asia - China (played out by Chinese stocks in Hong Kong), Korea and Taiwan - markets which were previously closed or heavily regulated, and now dominate the characteristics of this market. In short, the Asia of today is different to the volatile beast we saw previously. There is a lot more substance to this market, and a little less vapour.

On the flipside, Europe has disappointed in the down cycle, and because it tends to lag the US cycle, is less likely to improve at the rate of the US.

There are several reasons for this. For a start, the Europeans have historically been much less aggressive in cutting interest rates than the US, and appear to be more cautious about inflation. Also, European companies don't tend to have large US operations, so they are quite export reliant when looking for external growth. So, before we see a pick-up in Europe, you'll need to see a stronger US, and an increase, or the perception of an increase, in exports to that market.

While there aren't any major themes out there dominating global markets at present, making individual stocks all the more important, there are a few emerging regional and industry trends which are hard to ignore.

At the regional level it is hard to go past Japan, where a restructuring story is buried in a plethora of negative economic news. This is particularly the case in the banking sector, where restructuring has been massive, with the likes of Sumitomo Bank and Sakara Bank merging.

The potential for value creation here is quite large, although the risk involved in such environments is also big, so any enthusiasm we have here is certainly tempered by recognition of some difficult outside factors.

The restructuring of financials is not only happening in Japan. Indeed we've seen this happen in Europe, the States, and even North Asia, where in Korea we've moved our portfolio to take advantage of some interesting financial restructuring stories.

The other interesting development which has huge ramifications for telecommunications concerns DoCoMo, the dominant Japanese mobile phone company. DoCoMo is currently trialing the roll out of 3G mobile technology to its customers in a world first.

This interesting because the recent 3G spectrum auction process, and the subsequent debt problems inherited by large telcos (in particular the Europeans), saw a huge sell-off in this sector in the second half of last year. Similarly, the inability of technology manufacturers to deliver platforms and handsets for 3G as early as predicted saw companies like Ericsson suffer.

But after all the hype, and what some might say "overcapitalisation", the world now has a chance to measure the success of the 3G platform, see the effectiveness of the technology, and the quality of services offered to the end consumer.

This is of enormous importance because it is the first time we will have tangible evidence of the benefit and/or failure of huge amounts of technology and infrastructure spend globally. A successful launch could revive some optimism in the new economy story, and have particular benefit for those that have forked out in the spectrum process globally and the development of software for such systems. An unsuccessful launch could see these stocks come under further pressure.

Another interesting trend to have emerged over the past few months revolves around utilities, and in the under-investment that has occurred in the energy sector in the US.

A perverse ramification of the power shortages in California is the closure of a number of aluminium smelters, which has seen the global production of aluminium drop by around 10 per cent. The shift in market dynamics hasn't been priced into aluminium stocks, nor, in my view, has the market really priced in the opportunities to other utilities and infrastructure providers, where investment is long overdue.

When we talk about digestion, we are talking about the ability of companies to integrate and benefit from the huge technology spends they embarked upon pre-2000. We've seen corporate spend significantly dry up in this area, and the real test for reinvestment will be the results that are delivered through this tech spend.

The next few earnings results will give us guidance as to how well companies have implemented technology, and moreover, could provide upward momentum to the wider market in general, if the implementation has lead to greater company efficiencies as previously predicted.

But we still need to see a few more micro examples before we can have confidence that we are in a sustainable rebound mode. Our feeling is the market bottomed a few months ago, and we are in an upward, albeit volatile period, with much depending on company announcements over the next few months.

Chris Selth is head of international equities at BT Funds Management.