Long-term thematic investors, such as ourselves, have had to do a lot of soul-searching in the past month. The focus on the threat of inflation has intensified our fear that structural change could cease to be such a positive for our investments. Inflation figures still appear to be benign when one considers that stronger global growth is being experienced. Stocks have outperformed bonds and value has generally deteriorated sharply. Absolute P/E levels are historically high, and dividend yields are low. That said, the forward-looking earnings yield ratio is not excessive, standing at close to neutral.
The engine of global growth remains the US economy, which is going through a dramatic technological transformation. Productivity improvement cannot last forever and this led Federal Reserve Bank chairman Alan Greenspan to be more hawkish. He has stressed that the Fed will intervene if leading indicators shows inflation is likely to increase.
We see a further tightening in US Federal Reserve rates of at least 25 basis points this year. This has led us to be more cautious on long-duration assets. We feel that this tightening is already in the bond market and this is why the market is so preoccupied with economic data that might indicate that 25 basis points is not enough.
Globally, the outlook for growth has improved. Meanwhile, OPEC appears to have learnt a lesson on how to make a cartel work and has so far stuck to its output agreement. Static supply prices, global growth and the heatwave in the US have pushed oil prices higher. What can happen to one commodity can also happen in other commodities and services. Labour, in particular, is starting to show signs of costing more.
Meanwhile, in Europe the upswing in business confidence, and the maintenance of inflation at a low level, supports our underlying thesis on the region. The long-term outlook for European equities remains positive thanks to the restructuring of the corporate sector, higher returns on assets and equity and stronger demand for equities. The wide variation in corporate performance, however, leads us to caution that core Europe remains a stock-picking market.
The bottoming out of the euro is seen as an indication that the markets are sensing recovery and growth. In our domestic Nordic region we observe that stocks are very dependent on Asia and the dollar. Denmark is seen as a safe haven in terms of valuation.
Japan is beginning to surprise on the upside. Economic figures are surprisingly strong. Despite rising employment, consumption is up 4.9% and housing starts are strong. Capital inflows have picked up as overseas fund managers have begun to appreciate the trend. This has resulted in a strong appreciation of the yen. The appreciation of the yen versus the dollar is a concern but corporate Japan is largely locked in at a lower rate for the year.
Structurally, it should be remembered that some 36% of the entire market is held in cross holdings. The large companies may be slow to restructure but smaller Japanese companies that are privately owned have already streamlined their operations and this is seen as positive.
We are now overweight in Japan for a number of reasons. These include:
q A more stable economic environment.
q Accommodative fiscal and monetary policies.
q Japanese equity valuations are not stretched versus bonds.
q Japan is still far behind in terms of restructuring and economic recovery.
q Restructuring has finally gained momentum. Meaningful exiting of unprofitable businesses, elimination of excess capacity and strategic reorganisation is taking place.
q Expectations of cyclical earnings rebound.
The crisis in Taiwan is concentrating minds ahead of the election in March 2000. We now see this as a risk to our scenario. The heavy US involvement in Taiwan is comforting but it is felt that the possibility of China seizing Taiwanese assets on its own territory is real.
The result of the various mixed macro-economic signals has been a fall in risk aversion in respect of assets dependent on economic growth and an outperformance of cyclical equities. Commodities, emerging markets and Japanese equities have benefited. Long duration growth stocks and financials have under-performed. We are biased in favour of bonds but maintain our long-term equity bias.
Daniel Broby is chief portfolio manager at Unibank Investment Management in Copenhagen