On balance - equities over bonds
So now we know. US economic growth is back with a vengeance. Can that extraordinary performance, beyond some observers’ wildest dreams, bring out more bulls on Wall Street? Volatility is suspiciously low, and on any weaker piece of news market participants who bought stocks for the short term may take profits. At the same time, both individual and institutional investors who invest for the long term have not really moved into the market. Let us look at the issues that are still bothering them.
First of all, is the growth sustainable? Tax cuts did, of course, jump-start the economy, but now the engine is running, as evidenced by the facts that the job market has stabilised, consumer incomes are rising sharply and capital spending is beginning to pick up. Corporate profitability is on a sounder footing now that costs are under control and sales are reviving. After accelerating, the US economy will have to settle down to a more sedate pace in 2004, like a three-ton sedan from Detroit, but at least the engine should not stall at the first gradient.
What will the stimulation packages cost? By increasing the twin deficits and flooding the financial channels with liquidity, they are potentially inflationary. Still, mainly because of the corporate cost-cutting mentioned earlier, and of Asian competition, there is little risk of inflation in the months ahead.
The Fed will probably wait for the labour market to improve further before raising rates, starting in mid-2004. Fed hikes are likely to be gradual, keeping policy fairly accommodating by historical standards. Yet the current slowdown in the growth of the monetary base looks like a forerunner of action on short rates.
Asian economies have been re-accelerating in China’s wake. Although Japan’s domestic economy is still suffering from deflation and an inefficient banking system, the overall growth outlook keeps improving thanks to capital goods exports. Stronger demand for those goods has improved the growth outlook for Euroland as well. Trends in consumer and business confidence suggest stronger domestic demand. Growth will remain below potential, though, as corporate restructuring is not over and the labour market should stay weak until the second half of next year. The ECB will probably follow the Fed with a lag of several months.
With growth accelerating worldwide and deflation fears diminishing accordingly, the outlook for bonds is becoming more challenging. Despite their correction, US Treasuries are not cheap based on the growth and inflation outlook. Real yields are not compelling given reflation and debt levels, which could translate into excess supply. We would continue to prefer euro government issues, with some diversification, for example in Sweden.
Corporate bonds should still benefit from the economic environment, but credit spreads have become unattractive at current levels. While we had favoured this asset class, we will have to be more selective from now on.
Long term, US foreign financing needs will continue to weigh on the dollar. Other currencies, and not just the euro, will ultimately have to share the burden of the dollar’s adjustment. However, its downfall has already been sizable, while growth will support demand for US assets and a dollar devaluation would not solve the trade imbalance with China. We therefore expect the current euro/dollar trading range to hold for several months, albeit with high volatility.
We continue to prefer equities over bonds. In global balanced accounts, we are keeping the overweight position in them that we had initiated in the second quarter. Corporate profitability has been restored thanks to aggressive cost-cutting. It should now also be supported by sales volumes and, selectively, by a less negative pricing environment. Valuations are starting to diverge again, however. In the US, the rate of growth of GDP and of profits will stay quite satisfactory in absolute terms, but investors’ expectations have built up. That has not happened to the same extent in Europe, which looks better value in comparison. The valuations of Asian equities, including Japanese ones, are still historically low and will continue to benefit from the cyclical upturn.
Central bank liquidity is still supportive for equities. However, it has started to decelerate and will lead to a shift in regional and industry preferences down the road. More central bank tightening could signal an end to the liquidity-driven plays that currently enjoy the strongest momentum. So we have been increasing energy and telecom services, and are watching out for subsequent rotation into defensive areas – that is, Switzerland and the Netherlands on a regional basis, industries like insurance, consumer staples and retailing and very large caps at the expense of small and mid-caps.
Our equity exposure is therefore likely to turn more defensive in early 2004. But for the time being we continue to favour Asia, including Japan, more cyclical industries such as information technology and themes related to property and commodities.
Patrizio Merciai is co-head of investment strategy at Lombard Odier Darier Hentsch Group in Geneva