Nevertheless, as US and European equities enjoyed steep gains over the last few years, we anticipate periods of weakness in the short term. We therefore favour hedge fund managers who can profit from declines while maintaining selected long exposure. We also recently increased allocations to trading managers whose performance is non-correlated or inversely correlated with markets. Given patchy recovery and excess capacity in continental Europe and Japan, the US dollar should continue to strengthen against the Deutschmark and the yen.
Although US equities will remain volatile as bond prices and the Federal Reserve respond to inflation scares, we see numerous opportunities among small and medium-sized companies which have lagged the Dow. We also favour sectors that have already suffered corrections, such as technology and healthcare. The recovery of the banking sector, which is benefiting from low inflation, healthy loan rates, new technology and consolidation, has further to run. Nevertheless, we are cautious on the overall market. Our exposure is biased towards managers capable of reducing risk quickly and profiting from corrections.
Continental Europe has benefited from an exceptional combination of low interest rates, high liquidity and the promise of earnings growth due to strong exports, corporate rationalisation and gradual recovery. Although investors have favoured economically sensitive stocks over growth stocks, the market should become more discriminating. For example, some chemical companies have reached multiples normally associated with growth businesses, levels which are unsustainable for commodity, cyclical industries. We see value in certain manufacturing assets, but continue to select stocks carefully, avoiding sectors that lack pricing power.
Monetary union is likely to proceed on schedule with a core group of countries. Since those not in the first wave will nevertheless be working towards this end, European bond yields should continue to converge.
The UK market's positive response to the Labour landslide is a measure of the achievements of the Thatcher/ Major legacy, the economic changes of which are irrevocable. The new government's decision to give the Bank of England control over monetary policy has reduced inflationary expectations and gilt yields, providing further encouragement to equities. Assuming no exogenous shocks, the market should make further progress. Whether or not the UK enters the ERM, sterling is likely to stay strong, a trend that will bring new disciplines to British industry. We favour domestic cyclicals.
In recent months, Japan has been a two-tier market" with banks, brokers and construction companies particularly weak. We continue to focus on technology exporters, with P/Es in the low twenties and non-bank financials, with P/Es in the low teens. In addition, we like retailers whose strong balance sheets will allow them to expand at the expense of smaller operators. Finally, we are looking at selected real estate stocks and at quality cyclicals which have been ignored by investors but which should benefit as economic recovery broadens out. The Bank of Japan's recent tankan survey showed continued weakness in smaller companies and the non-manufacturing sector, suggesting that interest rates, despite having bottomed, will remain low for some time.
In the smaller Asian markets, recent weakness has produced compelling valuations. Selected companies should perform well if share prices move in line with earnings growth, requiring no re-rating.
Dana Moore is with Global Asset Management in London"
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