Financial markets are searching for the global economic rebound. Any encouraging signs are greeted with recovery trades in equity and bond markets. However, these trades are just as quickly unwound when the economic news becomes more sombre. Chances are that an erratic global economy will continue to feed market volatility. The recovery path will be bumpy and the risk of setbacks is considerable in the near term. Our stance on the major asset classes remains cautious. The focus is on regional differentiation within the asset classes.
The year in financial markets started with a surge in risk appetite boosting equities and hurting government bonds. Tentative signs of a US economic recovery encouraged investors. However, the bout of optimism was short lived as economic news proved highly volatile and attention shifted to the potential fallout from a war in Iraq. With markets bouncing between optimism and pessimism, we stress three factors, which are important when designing an investment strategy under high cyclical uncertainty. First, it is not unusual, that the news flow close to an economic turning point is very volatile. The cyclical upswing follows a period of pronounced economic weakness. Consequently, coincident and lagging evidence of economic weakness and leading signals of an imminent recovery are likely to ‘coexist’ for some time. The current volatile news flow is therefore not in contradiction of a recovery scenario. Second, during a cyclical rollover, the economy is highly vulnerable to external shocks since growth has not yet developed any self-sustaining momentum. Shocks to consumer confidence or heightened uncertainty among businesses can therefore foil an imminent cyclical take-off. This is the channel through which geopolitics and higher oil prices could spoil the recovery. In this context, we remain concerned that financial markets have not yet built up a sizeable cushion against bad news. This suggests significant negative shock potential in the case of bad news, for example related to Iraq. Third, the current economic cycle is disturbed by structural disequilibria and adjustment processes resulting from the New Economy bubble. Stretched household and corporate balance sheets will slow the recovery momentum and create additional downside risks in the form of additional shocks to consumption or investment.
We maintain a cautious investment stance on government bonds. Instead of implementing a highly cyclical bond-equity asset allocation, we focus instead on establishing regional bets within the respective asset classes. Government bonds on both sides of the Atlantic continue to anticipate a fairly grim economic outlook as is indicated by the depressed level of real yields in both markets. For the time being, however, the resulting upside for yields in case of a cyclical recovery is offset by geopolitical risks. Should bad news emerge from one of the geopolitical hotspots, the resulting search for safe havens would push bond yields lower. In the medium term, we therefore remain neutral on bonds, but choose to focus on regional plays instead. We expect the spread of European bonds over US Treasuries to narrow further. In a situation of heightened risk aversion, the US dollar and consequently US assets are likely to suffer disproportionately suggesting Eurozone – US yield spread compression. This is reinforced by our conviction that the misalignment of real yields and economic fundamentals is more pronounced in the US. Consequently, euro bonds are likely to outperform. We maintain a structural underweight on Japanese government bonds.
The current equity bear market shows all the characteristics of a structural bear market. After three years of painful adjustments we believe that 2003 is likely to mark the return to modest returns in major stock markets. In the short term, however, we maintain a very cautious stance. While staying neutral on global equities, we do, however, have well defined country and sector preferences. We maintain underweights on US and European equities while overweighting Asian (excluding Japanese) equities. We are drawn to Asian equities by attractive company fundamentals: low debt levels, increasing ROEs and high dividend yields. Our sector choices are determined by the search for growth. Sectors which can deliver sustainable growth in a weak top-line growth environment are likely to attract a premium. We therefore favour pharmaceuticals and telecoms while under weighting cyclicals.
The euro has continued its run against the greenback. While this has brought the single currency undoubtedly closer to fair value against the US dollar, we do not believe that the euro has become excessively strong. Since we believe that the fundamental driver of the current correction, the US current account deficit, is likely to remain in place for some time, we are confident that the euro appreciation has still further to go.
Markus Krygier is head of strategy at Credit Agricole Asset Management in Paris

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