The world economy is approaching a turning point. Given the current uncertainty, the asset allocation for our Euro-zone portfolio is structured cautiously. But, investors should look for the silver lining and be prepared to rebalance asset allocation aggressively.
For the first time since the 1970s and 1980s, the economies of the world regions are turning down in sync. The terror attacks on 11 September have further intensified the negative sentiment. To counter the increasing risks, central banks have further lowered interest rates world-wide. Consequently, financial markets will oscillate between the scenario of a longer global recession and a quick recovery in the foreseeable future.
The US is clearly leading the way with its expansive monetary and fiscal policy, but other central banks also loosened the monetary reins. We expect a synchronised upswing of the world economy beginning in the first quarter of 2002, which will additionally be reinforced by the low oil price. In that way, effects of a synchronous economic downturn were underestimated, the interacting effects of an upswing will be underestimated, too.
Particularly the Euro-zone will benefit due to its export orientation from the recovery of the world economy. This will also turn around the current negative sentiment. The negative sentiment in the corporate sector of the Euro-zone, illustrated by the ifo-Index and the INSEE report, indicated in November an increased recession risk. Through the ‘automatic stabilisers’, fiscal policy is supporting business activity. But the ‘stability pact’ makes it impossible to launch big fiscal programmes like in the US. In Germany, the budget deficit will reach 2.5% of GDP and approach the 3% mark.
A significant recovery in 2002 will be achieved by the upswing of the world economy and the transition to an expansive monetary stance in the Eurozone. On 8 November 2001, the ECB surprised the markets with a bigger than expected interest rate cut of 50 basis points as reaction to the risks to economic growth. The rate cut was made possible by falling inflation, which fell from its peak of 3.4% in May 2001 to 2.1% in November.
Despite the low refinancing rate of 3.25%, we see chances for a further rate cut by 25bps until February 2002 due to further weak economic data. But in fall 2002, we expect an increase of 50bps as the economic upswing gains momentum.
Given the above-mentioned environment, equities represent the most attractive asset class. In our Euro-zone portfolio, equities are slightly overweighted (53% versus 47% bonds). We have not yet made any aggressive sector bets as it is too early to focus on any sector trend. Despite the uncertain economic outlook for the Euro-zone, we recommend overweighting pre-cyclical stocks. With improving sentiment and higher purchasing power, we expect a particular impulse for the consumer sector.
We have slightly overweighted technology stocks as valuations look reasonable and the replacement cycle is becoming more and more important. Defensive sectors look expensive and should be underweighted. Markets are still moving on thin ice. Many investors are still hesitant regarding forthcoming economic and political developments. Furthermore, we see an increasing probability for profit-taking after the strong equity performance in October and November. Nevertheless, the valuation of European stocks looks attractive, relative to other major equity markets.
The more the markets anticipate an economic upswing, the more attractive becomes equity investments. The central banks will continue to provide ample liquidity. In the Euro-zone, huge amounts of money are also parked in money market products by private and institutional investors. Rising long-term interest rates will put only limited strains on the equity markets. The signs of a recovery of the economy and corporate restructuring will contribute to earnings surprises. Currently, restructuring costs are still weighing on the quarterly results. In 2002, leaner cost structures and a stabilising production would be sufficient to achieve an increase in corporate earnings.
In 2002, we see a potential for a setback in the fixed income markets. In the coming months, we expect them to move in a trading range. Currently, we are actively managing duration around the neutral position. The following example demonstrates the importance of this for the performance. In November 2001, the yield of 10-year US-Treasuries reached the year’s low, before increasing by up to 75bps.
In continental Europe, the volatility was less intense due to weak economic data. In the Euro-zone, the fixed income market will be driven by positive and negative factors. Positive for bonds will be the low inflation, which will stay below 2% from the first quarter onwards, and a steep yield curve. The synchronising of the upswing of the world economy will rather have a negative effect.
Overall, we expect government bonds to be under pressure in the course of 2002, while corporate bonds will benefit from higher growth and decreasing risk aversion of investors.
Rainer Matthes is managing director of Metzler Investment in Frankfurt