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Special Report

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Go overweight in Europe

Emerging market troubles continue to dominate the global equity markets. The situation in Asia is deteriorating further and we are witnessing a sharp decline in sentiment towards the region generally. Political tensions are now adding to the regions woes at a time when foreign investors need reassurance before returning. The banking systems are desperately in need of recapitalisation and foreign capital is simply not prepared to finance this in a number of the Asian countries. All of this makes us extremely cautious of the Asian region, where we think that the situation is set to get worse before it gets better. Perhaps not surprisingly, we view the area as unattractive for both equities and bonds.

The risk now to global equities is that the emerging market crisis could spread on a large scale outside of Asia. The Russian equity market has already suffered, and has plummeted in US dollar terms since the start of the year. The threat of South America following suit is now very real. In the developed markets, we have witnessed sharp declines and increased volatility as investors reconsider their risk tolerance in light of this situation.

What we believe has happened is a repricing of risk to ensure that developed equity markets are now fairly priced. On the positive side, the low interest rate and benign inflation environment should provide support for equity markets.

Within equities we continue to prefer continental Europe. We believe that it is too early to see any serious earnings downgrades and expect earnings growth to be around 15% for this year. In the UK, growth is ex-pected to be lower as recent economic statistics point to a slowing economy. However, the consensus view is that short term interest rates are at or near their peak and we believe that the Monetary Policy Unit will now reduce rates. On balance we view UK equities as a defensive market within global equities.

In the US, consumers, aided by low interest rates, low inflation, low oil prices and the lowest unemployment rate in three decades, are expected to provide support for the US economy. This should to some extent offset the slowdown in earnings which is now becoming apparent.

We recommend a neutral to slightly underweight position in the US and an overweight position in the UK and continental European equities.

What has been bad news for equities has generally been good news for bonds as risk averse investors have sought a safe haven. US treasuries have benefited greatly from this and we have seen bond yields fall across the yield curve. In the short term there is clearly a risk that some of the recent gains could be lost if this capital flow reverses. However, our underlying view is that 'safe' bonds remain in a bull trend supported by low global inflation and demand continuing to exceed supply. We would therefore prefer bonds to both cash and equities in a global portfolio, and view US bonds as particularly attractive.

Paula Dawson is with HSBC Asset Management in London

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