The keys to an economic upswing are again households in the US. The question is whether they will increase spending or focus on the rising unemployment and therefore be cautious.
Until the market participants become more confident about a recovery, the financial markets could be quite volatile, and we recommend a slight overweight of equities versus bonds. The leading economic indicators point towards a strong rebound in the US, but all eyes are also on the earnings reports and especially the earnings guidance from the companies.
Looking at the remainder of 2002, equities should outperform bonds, though we expect neither the US nor the European equity market to soar back to the 1999 levels on a 12-month horizon. A strong rebound in economic activity will help lift earnings, though the low utilisation rates and lack of pricing power will limit the ability to increase profits markedly. Interest rates in the US are low, but the financial markets are preparing for a tightening of short-term rates.
We expect stocks to modestly outperform bonds in 2002. We are looking for S&P 500 earnings growth of 20%+ compared to the consensus estimates of about 15%. Based on consensus earnings estimates, S&P 500 is currently trading at a P/E (12 months forward) of 20 times equal to an earnings-yield ratio of 1.0.
Based on valuation, equities still looks expensive, but based on our relatively bullish forecast for earnings currently we recommend a slight overweight of equities. An institutional investor with a strategic equity weight of 50% and a deviation range of 30%/70% should allocate 55% of the portfolio to equities going into the second quarter of 2002.
Better than expected earnings will improve equity valuations, and we expect the S&P 500 earnings yield-ratio to drift back towards the long-term average of around 0.9, implying an 8% potential for S&P 500 in 2002. Not really impressive in light of the average 1990s returns, but attractive when compared to the current level of interest rates. Ten-year government bonds are thus yielding less than 5%, and capital gains are rather unlikely given the expected improvement in the economic outlook. Looking at equities from a more structural perspective, investors should prepare for a longer period of modest equity returns. The bull markets of the 1990s were, to a large degree, driven by a re-rating of equities on the back of declining long-term interest rates brought about by falling inflation rates. Globalisation, breakdown of trade barriers, reduced power of trade unions etc have brought an end to the inflationary era on a global scale. Inflation will probably remain low and stable in the years to come, which is basically positive for equities. On the other hand, a further substantial reduction in inflation rates is neither likely nor desirable in either the US or Europe, and the re-rating of equities is therefore probably behind us. Based on a real interest level of 3%, an expected inflation rate level of 2-3%, and an equity premium of 3-4% we expect equities to post annually average returns of 8-10% in the coming decade.
Regarding the sector allocation we have divided the world stock market into six sectors with portfolio managers dedicated to each sector. Geographic allocation is only given secondary priority. Within the sectors we combine a bottom-up approach with a selective stock picking approach. Currently we overweigh consumer goods, health care, services and technology, and underweigh cyclicals and financials.
Within these sectors, we will highlight some overall conclusions:
o The market leaders in consumer goods consolidate their market position due to strong brands, and distribution is a key factor for success going forward.
o Within financials, earnings are depressed by a slower investment banking activity and increasing provisions for bad loans. The latter will probably continue in the immediate future.
o Cyclicals are, in general, highly influenced by the expectations for the economic upswing. Since the stock market already has discounted a strong rebound in the US, we therefore recommend underweighting the sector.
o The health care sector has an attractive valuation. Patent expiration has been very much in focus, but as investors risk aversion declines, focus is expected to shift to the promising pipeline in the biotechnology sector.
o Services will benefit from more advertising, which we expect during an economic upswing. After September 11, we also expect an increasing investments in security services.
o Semiconductors are expected to lead the technology sector like in the prior upturns.
In light of a possible unclear trend in the stock market, we stick to a thematic stock selection, and in general we favour market leaders. Themes in focus are outsourcing, the demographic development with continuously more elderly people, a pension reform, an increasing demand for security and insurance, and finally an increasing economic growth in China.
Niels Antonsen is chief portfolio manager and Klaus Hector Kjaer is chief strategist at Gudme Raaschou Asset Management in Copenhagen

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