Solid base to recovery
The present rally of the stock market appears be based on solid fundamentals. Gloom-and-doom scenarios about a new recession or deflation are being shelved and even fears of a ‘jobless recovery’ are starting to recede, now that in the US labour market indicators have taken a turn for the better in recent weeks.
Our strategy is based on the expectation of a robust economic recovery in the US, underpinned by a broad range of demand-side components.
We also expect the economic recovery in the US to rub off on the rest of the world.
Global inflation is under control, thanks to robust productivity gains and wage restraint and despite rising commodities prices, and central banks are keeping their key rates down.
We do not expect the bond yield to rise sharply in either the US or Europe in the months ahead. However, in a climate of economic expansion, inflation expectations surface quickly – rightly or wrongly – and the interest rate risk remains an upside one.
The vigorous recovery of earnings could continue. Based on a sample of 40% of the S&P 500 companies which have already released their results, third-quarter earnings in 2003 will increase by more than 20%. In spite of the recent rise in share prices, shares are still undervalued, certainly compared to (expensive) bonds.
As a result of these financial and economic scenarios we have further increased the overweighting of equities into our balanced portfolios. They now account for 55% of the balanced portfolio (see table), which means we have now reached the upper limit laid down in the risk budget. This strategy is providing the biggest test for the portfolio’s tracking error. Active positions within the bond or equities portfolios, therefore, have to remain limited.
The modified duration of the bond portfolio is 4.6 years, roughly 85% of the benchmark’s. Although the compensation for the credit risk is currently much lower than a few months ago, we are continuing to overweight corporate bonds in the bond portfolio. The faster pace of economic growth is good news for companies that are doing everything in their power to reduce their debts. Their efforts have already led to a substantial decline in the net issue of corporate paper. On the other hand, the supply of government paper will increase due to the pressure exerted by the deteriorating budgetary situation.
The correlation between the American and European stock markets has become so high that it is difficult to make a distinction between them. All the same, we slightly prefer the US to Europe, as the economy started expanding there first and growth will also be more robust. In Europe, the earnings outlook is being undermined by the depreciation of the dollar. Unlike the situation in Europe, earnings forecasts for US companies are also being revised upwards at a fast pace.
The pro-cyclical sector allocation is reflected in the overweighting of materials, capital goods, hotels, restaurants and leisure, media and software and services, and the underweighting of utilities and consumer staples. The robust trend of commodities prices is the main reason for overweighting materials.
High demand in China will continue to support commodities prices in the months ahead. This sector traditionally turns in a very strong performance in the first stages of a synchronous global economic upturn. This last point also benefits capital goods, in this case the manufacturers of electrical equipment and machinery.
For media, the improvement on the advertising market is a determining factor. The outlook remains favourable, due in part to the upcoming presidential elections and the Olympic Games.
Lastly, software and services – characterised by its high beta factor – still has much to gain from a further rally on the stock markets. In particular, applications software firms are likely to attract the lion’s share of IT (software) investment in the coming quarters.
The underweighting in financials and utilities reduces the portfolio’s sensitivity to interest rates. We are continuing to pursue our strategy within financials, but we are rather negative about banks. In the US especially, we expect traditional retail banks, with very little trading business, to underperform on the stock markets. We have strong reservations about life insurance companies. Within the sector, we therefore prefer non-life insurers.
Luk Van Heden is chief strategist at KBC Asset Management in Brussels