Merrill Lynch predicts soft landing, improved stock markets

Merrill Lynch sees soft landing of the world''s economy, improvement in equity returns in 2001.
Merrill Lynch Investment Managers, the fund management arm of Merrill Lynch, predicts the global economy is headed for a soft landing and that equity markets will improve in 2001.

Still, the company warned Hong Kong investors to diversify their portfolios away from the Hang Seng index, which, because of the high number of banks and real estate companies, is more sensitive to interest rate fluctuations and more volatile than other indexes.

Over the past five years the Hang Seng has under-performed the world's stock markets by about 3% a year, says Graham Bamping, director of investment communications for Merrill's Global Mutual Funds in London. However, over the past 10 years the Hang Seng has outperformed the world's indicies, albeit with a great deal more volatility.

"We think there are strong reasons why investors should look to invest elsewhere in the world to get access to different asset classes than are available here," says Graham Bamping, director of investment communications for Merrill's Global Mutual Funds in London. "The Hong Kong stock market is full of excellent companies, but it represents less than 1% of the global capital market."

In the five years to October 31, 2000, the Hang Seng returned 12.1%, compared to 15.2% by the MSCI World indexes. In the 10 years to the same date, the Hang Seng returned 21.4% compared to 13% for the MSCI World index. Even investors with a long term horizon should diversify to reduce risk, Bamping says.

When diversifying, investors should also look for stocks that have a low level of correlation with the Hang Seng; that is, stocks that don't move at the same time or in the same direction. If correlation is low it is possible to produce a lower overall portfolio risk and higher return, even by adding a "higher risk" asset, Bamping says.

On a regional basis, returns on equities in all major areas of the world have been negative this year. Regions that outperformed in 1999 – the Pacific basin and Japan – under-performed in 2000. On a sector basis, the telecoms and technology shares that outperformed in 1999 are being pummeled in 2000. Cyclical stocks have also taken a beating this year amid concern that the world's economy is in for a hard landing.

Even so, investors who picked stocks based on sectors could still have made money this year if they invested in defensive stocks such as pharmaceuticals, energy stocks and utilities, Bamping says. Over the past five years, multinational companies – defined as those that make 30% or more of their revenue outside their domestic market – significantly outperformed companies focused on just one market or economy; and they continue to outperform in 2000.

"Globalization is the mechanism whereby capital flows to companies that are doing the best job in terms of providing the highest return on equity," Bamping says. "Cross-border mergers and acquisitions have risen rapidly over the past 10 years. We expect it will be tough to keep up the level we've seen in 2000 next year, but we still think there is going to be a lot more cross-border M&A activity, which is a fundamentally positive factor for stock markets over the long term."

Bamping says that although he expects the equity markets to improve in 2001, he doesn’t expect them to go back to the 20%-plus levels of return of the mid-90s through 1999. Neither does he think such returns will come back any time soon. The reason why equities have performed so well over the past five years has less to do with corporate earnings growth than with expanded valuations, he says. Price to earnings ratios on the MSCI World index rose to 35 times at the end of 1999 from 20 times at the end of 1995.

The key reason for the higher valuations is that governments are now better at macroeconomic management. In the last 20 years the economy has been expanding 96% of the time, giving investors greater confidence and enabling companies to make more accurate assumptions and forecasts for growth.

"Investors tend to project into the future what has happened in the past, leading to the phenomenon of extrapolation." Bamping says. "We believe that is a flawed way of looking at things. It's a view that implies that the equity risk premium can go on contracting forever and that price-to-earnings levels will go on expanding forever."

The consequence of extrapolation is that this year, even though corporate earnings went on growing, share prices fell because investors had been projecting a level of growth in the equity market that was unsustainable long term.

"The result is that now things have got back into a more realistic territory," Bamping says. "P/E ratios have fallen, corporate earnings remain good and we think it is fundamentally quite encouraging that investors are taking a more sound view of how equities should be valued."

On the fixed income side, Merrill Lynch predicts that next year bond yields will fall as economies slow.

"The challenge here for equity markets is that not only will bond yields contract but corporate earnings are likely to slow next year," Bamping says. "In our view whilst growth will slow it will remain positive and the economies are likely to soft land."