The Terrorist Premium

07/15/2005 12:00 am EST

Focus:

Joe Battipaglia

Market Strategist-Private Client Group, Stifel Nicolaus

While recognizing the powerful emotional impact of the terror attacks in London, Joe Battipaglia of Ryan, Beck & Co. takes a step back to help investors assess the financial implications of the tragic event and what effect these developments might have on your investment portfolio.

"Just prior to the terror attack, London's stock market reached a three-year high, celebrating the success of the UK economy and the potential for an interest rate cut from the Bank of England. The world's attention had been drawn to England as the host of the G-8 Summit in Scotland and its selection to host the 2012 Olympic Games. The despicable terror attack in London was timed for political effect and has modestly disrupted global financial markets on a short-term basis.

"Unfortunately, western societies have come to expect some type of terror attack somewhere from time to time. As a result, terror risk premiums already exist in all financial markets, in particular, oil that is already in a tight supply condition, US Treasury bonds that are considered a safe haven, and equities that carry higher risk premiums (lower P/E multiples) than they might otherwise carry at this point in the economic cycle.

"We do not expect this soft-target attack to interrupt global economic activity. We have seen economies and markets advance from these attacks in the past with the Madrid attack 16 months ago. The aftermath of this attack should be no different. While the market has been troubled by a rebound in oil prices and no change in Fed policy towards rate increases, we start this week with some important positives on the underlying economy. Manufacturing picked up some momentum as the ISM index of manufacturing jumped up in June to 53.8 that was higher than economists expected and represented a turn for the index, which had been declining in recent months.

"Business confidence to spend on additional capacity is a vote of confidence in the current expansion and adds to the job market and incomes. In the past year roughly two million jobs have been added, which has helped to produce an additional $475 billion in disposable income and spending. In our view, the consumer will be just fine in 2005. This all adds up to at least a 3% real growth in the US GDP and 10% profit expansion for the S&P 500 which we believe to be undervalued by approximately 10%.

"Interest rates in Europe should remain low as economic growth in the Europe zone remains sluggish and unemployment is high. In fact, there is some speculation that European central bankers will be forced to cut rates. While US investors complain about the paltry yields offered by Treasuries, consider investors in long-term rates of other countries such as Germany (3.2%yield), Japan (1.2% yield), France (3.2% yield), and United Kingdom (4.2% yield). The average non-US yield is under 3%. By contrast, the ten-year US Treasury is over 4% and appears to be a bargain. Should Europe’s yield curve move lower as the US curve stays the same or moves higher, we would expect that foreign investment flows improve in favor of US financial markets.

"While Europe struggles, businesses in developed nations are finding ample investment opportunities in other places. The OECD estimates US companies invested $252 billion in foreign businesses and assets last year, up from $141 billion the prior year. This behavior suggests that business spending and investment is optimistic about future growth prospects globally and here in the US. Also, investment by the 'developed' world economies in 'emerging' market economies, which includes China, grew to a record $261 billion in 2004 versus $134 billion in 2003. The level of investment will continue to expand market share of the global economy for the largest multinational companies, and foster continued expansion of global commerce, competitiveness, and trade between the developed nations and the rest of the world.

"As expected, the rate of growth in the US has slowed from the pace seen last year. Energy prices, higher rates and a lack of new fiscal stimulus are all part of this slowdown, but the fact that inventory levels have been brought more in line with demand are all part of the normal ebb and flow of the economy. The aggressive discounting going on at General Motors speak to the efficiency and faster speed with which inventory adjustments can occur. Thus, unlike prior inventory led recessions, we expect current adjustments to prove short lived and the weakness seen in manufacturing may likewise reverse in 2006. We’ve made the case that spending by the consumer in the US will remain consistent with income growth and investment in the domestic economy will continue to expand at a modest pace.

"Overall, the muted global financial market response to the London attack demonstrates how investors have incorporated the terror threat in market valuations and expectations. We do not believe a change in asset allocation or forecasts are warranted and we maintain our current allocations in exchange traded funds. For growth investors, we recommend an 8% weighting in iShares Lehman 1-3 Year Treasury Index (SHY ASE) for an exposure to short-term Treasuries, and a 5% position in iShares Goldman Sachs InvesTop Index (LQD ASE), for exposure to corporate bonds. We suggest no exposure to REITs and a 2% position in gold. The balance of our ETF portfolio is allocated to stocks.

"We suggest a 24% weighting in S&P Barra Large Cap Growth Index (IVW ASE), a 21% weighting in iShares S&P Barra Large Cap Value (IVE ASE), 15% in iShares S&P Barra Mid Cap Growth (IJK ASE), 13% in iShares S&P Barra Mid Cap Value (IJJ ASE). For foreign exposure to developed economies, we suggest a 4% weighting in iShares MSCI EAFE Index (EFA ASE) and a 9% weighing in iShares MSCI Emerging Markets Index (EEM ASE), for exposure to the emerging markets sector."

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