Banking & Capital Markets

Investors See a Return to Normalcy

In survey, institutional investors say they expect more typical stock market returns this year; small caps, emerging markets will lead the way.
John GoffJune 24, 2002

The U.S. equity markets may be in full retreat right now, but that will change soon.

At least, that’s the upshot of a new survey recently released by professional services firm KPMG. Dubbed the 2002 Survey of Economic and Capital Market Expectations (the 26th annual installment of the report), the study includes responses from economists and investment strategists at 41 leading international financial institutions and investment organizations.

And according to those respondents, the U.S. stock markets will stage a sizable recovery this year. Says Rex Macey, director of research for KPMG Investment Advisors: “The survey… indicates that we should see the equity market normalizing this year, performing closer to historical averages.”

And what are normal returns? Somewhere around the 8 percent range, says KPMG. Considering the recent drop on all three major U.S. exchanges, most shareholders would probably be thrilled with an 8 percent return on their investments. “You won’t have the phenomenal returns of the late ’90s, nor will you have the bleak numbers from 2000 and early 2001,” says Rex Macey, director of research for KPMG Investment Advisors.

Interestingly, the investors and economists in the survey believe small-cap corporates will outperform large-cap businesses over the next decade. According to the respondents, small-cap equities are expected to produce returns of 10 percent this year and 10 percent in subsequent periods.

That’s not overly surprising. As Neil Wolfson, national partner in charge of KPMG’s Investment Consulting Group, notes: “Coming out of a recession, small-caps tend to increase more dramatically.”

Larger companies should do okay, as well — although not as well as they did in the go-go ’90s. Forecasts from the survey call for large-cap stocks to grow by 7.6 percent in 2002, 8.4 percent during the next five years, and 9 percent over the next 10 years.

Value stocks are expected to beat growth stocks in the U.S. over the short term — but not the longer term. “Stocks of large U.S. companies are forecast to produce respectable returns,” Macey says, “but below their historical averages.”

On the other hand, international stock markets are expected to outstrip their recent performances — and U.S. markets as well.

In general, international equities are expected to produce returns of about 10 percent annually over the next 10 years. Of that group, stock markets in emerging countries will be the best performers over the next five years, predict the respondents. According to the survey, emerging market equities will generate a substantial 15 percent return this year and a 12 percent annual gain over the next five years.

“The emerging markets are particularly hot, especially from Eastern Europe to Asia and even parts of Latin America,” says Wolfson. “Many stocks in those areas are just starting their earnings cycle and have profits growing.” According to the surveyed investors, emerging market companies are trading at very large discounts compared with developed peers and are currently considered a bargain.

Speaking of large discounts: Respondents in the survey see a big bounceback in corporate performance in the slumbering Japanese market — a market that has vastly underperformed for the past five years. Investors and economists predict that large-cap equities in the land of the rising sun will provide returns of 5 percent in 2002, then produce a competitive 10.5 percent annual return during the next decade.

In the United States, venture capital investments should be the best performers. Respondents believe VC investments will throw off a 10 percent annual return during the next 10 years.

While corporate share prices will go up, so will the cost of borrowing. Respondents said they believe U.S. interest rates will increase in the next five years.

That’s hardly a surprise. Most financial observers believe the Federal Reserve Board will jack up interest rates as the U.S. economy picks up. According to the KPMG survey, however, short-term rates are projected to jump to 3 percent in 2002, and to 4.5 percent by 2006.

Moreover, rates are expected to rise across the entire treasury curve, with the 30-year bond yield seen at 5.6 percent in 2002, rising to 6 percent by the end of 2006 and 2011.

Given this expected rise in interest rates, it’s not surprising respondents said fixed-income instruments will throw off sizable returns in the coming decade. Indeed, Wolfson says high-yield bonds are projected to generate the highest returns, providing 8 percent gains this year, and an average of 8.5 percent during the next five to ten years. Returns in all other fixed-income sectors are projected to rise over the next five-year period.

Financing News

If the KPMG survey is spot-on, the cost of borrowing capital is going to start going up soon.

It’s certainly hard to imagine interest rates going down anytime soon. In fact, corporate money-raisers continue to debt while the debting’s good.

Late last week, for instance, Sears, Roebuck and Co. issued $250 million in 40-year bonds — yes, 40-year bonds. Led by Merrill Lynch & Co., the issue size was expanded from an originally planned $200 million. The extremely long-term paper from Sears will yield 7 percent. The bonds were rated Baa1 by Moody’s and A-minus by S&P.

Hewlett-Packard Co., which recently merged with Compaq Computer, went slightly shorter than Sears. Management at the computer maker issued $1.5 billion in two-part global senior unsecured notes. HP management had initially planned to borrow $1.25 billion in the funding. All in, HP issued $1 billion of five-year notes, priced to yield 5.546 percent, or 152 basis points over comparable Treasurys, and $500 million of 10-year notes, priced to yield 6.506 percent, 175 basis points over Treasurys. Both issues were rated A3 by Moody’s and A-minus by S&P.

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