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In defensive mood

European institutional investors have to play a difficult game at what seems to be a difficult moment in time. The extremely bullish period on international equity markets, driven by strong momentum in ICT-related and other growth stocks came to a halt during this year. We do not believe the current volatility levels and the degree of market uncertainty warrant a clear stand strongly in favor of equities or against it. We do therefore recommend the following asset mix:
That is an equity allocation slightly below the 60-70% long-term optimum for the ‘average’ institutional investor. This is in line with our expectation that stock returns for major financial markets will be at best mediocre for the period November 2000 – October 2001. By analysing the composition of the 56.4% allocated to equities, we see the following distribution: The two traditional safe havens USA and Europe are both slightly under-weighted. We do strongly believe both major regions will have their difficulties during the coming 12 months. The uncertainty with respect to what is going to happen in the US is well illustrated by the confusion surrounding the US presidential elections. Economically the situation is not as exuberant as before. Inflation levels are slowly moving up, more and more people understand that Professor Paul Krugman is right in stating that “New Economy is not ‘miracle economy.’”When we also take into account that euro will sooner or later stop depreciating as compared to the US dollar and will probably even win back some lost territory, a strong US exposure obviously does not make sense. However, although less ‘New Economy’ sensitive, the European economies do – from a macroeconomic point of view – closely track the US, albeit at a somewhat less extreme level. Stagnation of growth or at least a slowing down of it is very likely.
Therefore what we end up with is a unique situation in which the periphery is relatively over-weighted. Within the periphery we see a more or less equal distribution with a 9% investment in the Japan component, 6% in the rest of the world (developed markets), 7% in emerging markets and 6% in private equity. The total allocation of 28% of the equity asset class, ie 15.8% of the overall portfolio, seems relatively high and risky. However, publicly-listed equities in Japan, rest of the world (developed) and emerging markets on average did not share the same happy experiences over the last 3-5 years that were witnessed in the US and Europe. We feel that better times for these ‘laggards’ are on its way. Private equity returns over the last 3-5 years were good, especially in the ICT and biotech areas with incredible returns when firms went public, notably in the US.
Periphery markets do not just offer higher potential returns, they are carrying higher risks as well. In a mean-variance portfolio framework they are very interesting though because these periphery markets offer something that is truly becoming a scarce commodity, namely a relatively low correlation coefficient with major market movements.
The allocation to the asset class fixed income, 37.8% of the overall portfolio, is characterised by a relatively low duration induced by our expectation that interest rates will probably not stay stable. The foreign, ie non-euro, component is relatively low since we do foresee euro will appreciate versus the US dollar. The ‘specialty’ category consists of so-called ‘high yield’ bond strategies and convertible bonds.
Hence we suggest investing 61% of fixed income (that is 23% of the overall portfolio) in European bonds and money market instruments. The 55% of fixed income allocated to bonds (euro-denominated and other, representing 21% of the overall portfolio) is for two-thirds in the 1-5 years age class.
In conclusion, we would go for a less conventional asset mix taking into account our defensive stand. The major safe havens are either more or less index-weighted or slightly under-weighted. A relatively equally weighted portfolio in which peripheral countries within the asset class equities and low-duration euro-denominated fixed income securities play an important role is the result.
Erik van Dijk is CEO of Palladyne Asset Management in Amsterdam

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