Equity and bond markets made further progress during February, as investors reflected upon an economic background that continues to provide a sufficiently mixed picture to enable both asset classes to prosper. Emerging markets, particularly in Asia and Eastern Europe once again showed some of the best returns in $ terms, with European smaller capitalisation issues also reflecting investors’ continued robust appetite for risk.
The fact that investors are able to continue to tread a path between fears of too rapid growth, which would be reflected in rising employment levels leading to a re-acceleration of inflation and thus rising interest rates, and on the other hand fears of fading growth, which would put at risk the outlook for corporate profits, reflects the specific nature of this economic cycle.
The particular combination of economic, demographic and political factors currently shaping this cycle are encouraging investors to maintain their appetite for investment risk; key to this strategy is the Federal Reserve’s continued policy of low interest rates.China, together with other emerging economies, providing much of the labour required to meet additional demand from the strong US recovery.
Strongly rising commodity prices have had little effect in dampening enthusiasm for the low inflation/low interest rates scenario and investors have largely continued to pursue a pro-cyclical bias. Tightening resource utilisation rates and rising commodity prices would normally presage an about turn in central bank monetary policy and lead to a period of higher interest rates.
The overt statement by the US Federal Reserve that it sees no immediate cause to raise rates is keeping the short end of the yield curve down, whilst the long end is benefiting from the continued purchase of US bonds by Asian banks. This reflects a wish to recycle export earnings into dollar denominated securities in order to avoid a rapid appreciation of their domestic currency against the US dollar. Cyclical pressures will ultimately prevail and a period of rising rates will be discounted by the markets. However, in investment strategy terms, the timing of such a turn in policy is key.
Despite the strong stock market recovery over the last year, equities remain cheap compared to bonds and the factors that have propelled the equity recovery remain very much in place. Consequently we are of the view that the market advance will continue in the immediate future and have concluded that it would be premature to move to an overly defensive strategy at this time. Whilst we are of the view that further stock market gains lie ahead, it should be noted that there is evidence of heightened investor nervousness, as evidenced by the recent widening of emerging market and corporate debt spreads.
We believe that investors will have to remain vigilant for any change in policy by, particularly, the Federal Reserve and be prepared to adopt a more defensive strategy to reflect any change in risk tolerance. Although the US, together with China and other Asian countries, remain the principal locomotives of world growth, it is evident that Japan is beginning to show signs of what may well be a sustained recovery and emergence from its period of acute economic malaise. While much of the recent recovery can be ascribed to export-led growth to satisfy demand from China, it is evident that the consumer sector is also showing signs of growth and that corporate Japan has made significant progress in restructuring. The economy looks set to sustain growth in the region of 2.0% this year.
The recovery in growth, together with operating improvements following corporate restructuring, is being reflected in steady increases in estimates of company earnings. This improvement in operating performance suggests that corporate Japan will post record levels of profitability in the year ending March 2005.
We continue to view equity markets as attractive relative to fixed-income markets. Although the risk of a return to a more challenging interest-rate cycle has not been removed, it does not yet seem timely to move to an overly defensive strategy. As a consequence we are removing our earlier underweight position in the technology sector and moving to a neutral position.We are reinforcing our preference for eastern over western markets by moving to an overweight position in Japan. The exposure to Europe is reduced accordingly and we remain underweight in North America.
Richard Healiss is head of regional equities at Pictet Asset Management in London