The earnings growth signal
In late February, early March with the drums of war growing louder our asset allocation team moved from underweight to overweight equities. This was a time of great stress in the market place with liquidity varying from day to day, particularly as insurance companies sold equities to reduce exposure to a riskier asset class.
The recent sell-off in bonds has now confirmed this move – so far so good! The out-turn for the global economy is crucial for corporate earnings, investor confidence and stock and bond markets at this point. Consensus forecasts indicate that the global economy is expected to return to at least trend rates of growth later this year. We largely agree with these forecasts.An accelerating US economy is expected to lead the global economic recovery. Factors that have held back US economic growth – geopolitical worries, bad weather and fears of terrorism – have either disappeared or faded considerably.
Although confidence and consumer spending has not recovered quickly, the conclusion of the Iraq war and the stock market’s rebound is supportive.
US monetary and fiscal policy is strongly biased towards expansion and reflation; the US government and Federal Reserve are prepared to take whatever action is necessary to ensure a sustained upturn in the US and investors are confident in their ability to do so.
US interest rates were recently cut by 0.25% to 1.00%. The Federal Reserve stated that a more expansive monetary policy would add support to the US economy, given that the economy was not yet showing signs of sustainable growth and that upside and downside risks to this being achieved in the second half of 2003 were roughly equal.
Monetary and fiscal policy elsewhere is also expansionary. Regulators clearly want growth. Interest rates are at low levels and further cuts cannot be excluded, particularly in the Euro-zone. Globally, interest rates are likely to be kept at low levels and we are not expecting rates to rise in 2003.
Corporate earnings should continue to improve in the US and elsewhere. Earnings expectations are already improving slowly in the US. We remain on alert given that cost cutting has been a key driver of earnings per share progress, and that this cannot continue forever; we are therefore expecting top line growth to kick in as 2003 progresses. This, combined with rising confidence, realistic valuations and further injections of liquidity into equities should ensure that equity markets continue to progress over the next 12 months.
Bond yields have risen significantly over recent weeks, yet still remain below levels which we would consider to be very cheap on fundamental grounds. As a result, we remain overweight in equities and underweight in government bonds. We also note credit spreads have remained well behaved as bond yields have risen, again this confirms our decision to remain overweight in credit in bond portfolios. Improvement in the underlying economy is a common denominator explaining these moves so far.
Japan’s economic troubles are deep rooted and there is little light at the end of the tunnel for its economy or the broad stock market, so we are underweight Japanese equities. In continental Europe, although equities are more cheaply valued than US equities, the fundamentals are weaker. Portfolios are broadly neutral in continental European equities.
We favour continental European government bonds over UK, US or Japanese government bonds. The Euro-zone is lagging the UK and US in the current monetary easing cycle. Whilst further small cuts in rates in the US and UK cannot be excluded, we expect further reductions to be made in the Euro-zone, and these are likely to be of greater magnitude than any reductions elsewhere. As a result of this and the strong euro, the Euro-zone government bond market may enjoy a greater degree of support than other developed government bond markets.
Weightings in sterling corporate bonds are neutral versus underweight positions in UK gilts as we see greater value at the stock level for corporate bonds, particularly for lower rated credits. A sustained economic recovery would support improvements in corporate earnings and help companies with lower credit ratings to reduce their debt levels.
So, we remain overweight equities and even more vigilant for signs of top-line earnings growth to take over from cost cutting. If there is top-line revenue growth we will stay put – if not we may look for opportunities to lock in some absolute and relative profit.
Tony Broccardo is chief investment officer at F&C Management Ltd in London