Insitutions drive a weaker Europe forward
On the balance we remain overweight in equities relative to fixed income even though valuations by traditional measures seem high and earnings growth could slow down in the third and fourth quarter. Within equities we remain cautious, albeit overweight, about the US and have trimmed back our positions somewhat.
The following discussion gives the background on our views for a typical EMU institutional investor with a balanced portfolio. Actual portfolios vary according to client benchmarks and tracking error restrictions. Asset allocation at Fortis Investments is done by contrasting our views with ‘equilibrium’ returns of the client’s strategic allocation using an asset pricing model based on historical returns. The client’s allocation is only changed if our views are sufficiently strongly held to override the expected returns from the strategic benchmark. A proprietary model is used to perform the optimisation.
The economic outlook in Europe is not favourable. With few exceptions, very little progress has been made in solving the structural problems besetting the major continental European economies. The UK economy, which definitely is not in this class, is in a weak phase of the business cycle. The strong political pressure on the European Central Bank (ECB) to stimulate the economy by cutting interest rates will hopefully abate following the resignation of Lafontaine. We believe however, that after a face saving interval the ECB will cut short-term rates.
Equity markets in Europe have been boosted by institutional investors gradually changing their strategic asset allocations. The process of moving more towards equities, and the shifting away from the traditional bias towards the home country, is driving the valuation of the top tier of the market to ever increasing heights leaving small- and midsized companies looking like classical value plays.
We remain overweight in European equities. Our most favoured sectors are consumer-related: media; life insurance and banking, especially the asset gathering segment. The engineering and capital goods sector, which is out of favour at the moment with investors, has a number of very good quality companies with dominant niche positions which are gradually adding to the portfolio.
We remain overweight in US equities, despite the dizzying heights of valuations. Although we do not expect significant increases in company earnings, our strategy is underpinned by a strong outlook for economic growth. As a result monetary policy could tighten with short term interest rates increasing in the second quarter. This will have a positive effect on the dollar vis-á-vis the euro. Sectorwise we favour healthcare, technology and big consumer stocks. On a quarterly basis we forecast a total return on US equity of 4 to 5% for the next quarter.
Fixed income is slightly underweight in this portfolio. Our forecast for our euro fixed income portfolio on a quarterly basis is 1 to 1.5%. Duration is somewhat longer than the benchmark. Our mandates generally allow for an allocation of 20% of the fixed income portfolio in credits and this room for yield pick is generally fully utilised by investing in paper graded A- or better.
The indicators for Japan point to a stabilisation of the economy. Apparently the many government stimulation packages are helping. However, the combination of pervasive structural problems and a distressed financial sector explain our reluctance to take a positive view on Japan’s prospects. We expect returns on Japanese equities to be -2% in the coming quarter, influenced to a high degree by an expected weakening of the Yen. Japan is significantly underweight in this portfolio.
The economies in South East Asia look like they are finally reaching the bottom of the trough. But with the problems still facing Japan it seems too early for any real enthusiasm. Our projected rate of return for the region is 2% for the coming three months based mostly on expected appreciation of the currencies. The exposure to this asset class in the portfolio is minimal.
Roberto E Wessels is group CIO at Fortis Investment Management in Utrecht