In our opinion, the current US economic cycle, albeit some 10 years old, still has some fuel in reserve. Even though capital investment and construction have lost momentum, growth will be sustained by full employment and higher personal incomes. Consequently, we could see the US economy accelerating again following a brief poor patch, which would, after all, be beneficial for inflation.
The consequences for the other major economies would be positive. Although continental Europe is now growing fast again, thanks to the renewed momentum of domestic consumer spending, the export markets are still playing a significant role in the recovery of manufacturing employment. US demand is also essential for Asia, including Japan.
Inflation has become increasingly visible, but is not alarming because of the structural pressures on prices and also the moderation of wage increases relative to productivity gains. Central banks will have to remain watchful, though; the wave of interest-rate hikes has not ended in either the US or Europe, and it will soon begin in Japan. Furthermore, the continuation of world growth will prevent any easing of real interest rates, and thus bond markets will be kept in a comfortable but uninspiring range. However, that same growth will help to maintain corporate profitability. We are in for a relative respite for bond markets, although they will be upset momentarily by the impact of announcements of interest-rate hikes; we are also in for more balanced economic growth and momentum enabling strong earnings growth and giving investors an incentive to bet on the future. Consequently, we are confident in our global balanced portfolios, equities are slightly overweighted relative to bonds.
The somewhat relaxed period for bond markets has not quite come to an end, but the monetary tightening will affect short maturities. The average duration of our portfolios is thus longer than the benchmark’s.
For most markets, we prefer government bonds, the supply of which is continually shrinking because of the improvement in public-sector finances. Japan, needless to say, is an exception.
Regarding equity portfolios, industry-wise, we are confident on IT stocks, with a preference for major software and systems names, whose valuations are warranted by their earnings growth and margins. At least a neutral weighting should be maintained. However, we are underweighting telecoms, since their valuations are often too generous, especially in Europe.
In the traditional cyclicals segment, we favour capital-goods producers, due mainly to the recovery of the European market, as well as energy stocks.
The outlook for defensives is very mixed. Some large consumer-goods names are experiencing margin pressures, but healthcare valuations have become attractive again relative to the growth expected. Biotechnology should not be forgotten, as prices remain significantly below their peaks and buying opportunities remain. Regarding financials, the recovery of banks has wiped out the undervaluations that could have made them attractive. We prefer insurance stocks, especially those with a strong life business.
Geographically, we are underweight the US. Other countries hold a greater potential, with Europe taking the laurels: economic acceleration, earning power, renewed corporate momentum, fair valuations (ex telecoms) and frantic merger and acquisitions activity. The market is also broadening thanks to the recovery in second-liners that are more geared to the regional economy.
A noteworthy change in recent months is that the UK and Swiss markets are catching up with Euroland. Reasonable valuations overall and the lull as regards interest-rate hikes have been providing support for the UK equities. For Switzerland, the main driving forces have been the return to favour of certain industries like healthcare and the effects of the economic acceleration on earnings as well as confidence.
In our opinion, Japan’s recovery is one of the key themes of the next few years, but we believe that it is too early to overweight the region just yet. The economy could still bring some disappointments, and the indices are set to remain highly volatile, especially the Nikkei, since its makeup has been changed in order to make room for the tech stocks. Consequently, we adopt a selective approach, favouring those companies with the most successful restructuring and which are moving toward a sharp earnings pickup.
However, the time is ripe to add to positions in other parts of Asia, as valuations have declined whereas earnings are continuing to grow. That said, the overall picture hides some differences, and caution is warranted as regards Korea and particularly most ASEAN countries. Therefore, our vote goes to Greater China, ie Hong Kong of course, but also mainland China and Taiwan, not forgetting Singapore.
Patrizio Merciai is chief strategist at Lombard Odier Group in Geneva