The current investment climate can be characterised by three themes:
q Due to the renovating power of the application and development of information technologies the allocation of the production factors labour and materials is reshuffled and distribution systems are overhauled. As a consequence the third production factor, capital, is redistributed to those sectors that bring the changes about, the IT companies, with the dot.com companies foremost amongst them.
q Moderate, sustainable, economic growth and benign price inflation allows technical, logistic and financial reallocation without significant disruptions. At the same time the transformation contributes to growth and keeps prices under control.
q The adoption of the production system and logistics to the new technical possibilities is not confined to the traditional geographical borders. The way and the speed of the transformation depend on the flexibility of the socio-economic systems and the stage of industrial development. Between and inside these systems there is a sharp distinction between leaders and laggards.
The last remark indicates that there is no paradise without a snake or two.
The reallocation of financial resources have brought about an inflation in the valuation financial assets which does raise the question if the current discounting of future profits is not getting ahead of itself. At the same time the dispersion in appreciation of those sectors and companies that are perceived to be successful and those that are not, is very great. Changes in sentiment result in strong price movement and occur regularly. There is also a growing feeling that the beneficial effect of the lack of pricing power, in combination with a continuing economic growth and a potential spill over of the asset price inflation, will be increasingly difficult to maintain.
Where do these observations lead to in terms of asset allocation decision?
q The undisputed leader of the IT transformation, its development and application, is the US. Europe is a good runner-up especially because the necessary restructuring is boosted by the introduction of a pan-European monetary policy and currency. Japan has started the structural changes in its socio-economic systems. In this country the difference between traditional and new is very clearly reflected in the equity market. The emerging markets have benefited from the global economic growth; instead of being a drag they now even contribute to the expansion of economic activity.
q The premium that is paid for the leaders in the transformation process does reflect the better growth potential while in general the valuation of equities discount a continuation of the favourable economic background and positive earnings expectations. These valuations are in contrast with the interest rate development, which reflects a more cautious outlook with regards to price inflation and less easy monetary situation.
q While maintaining the long-term favourable outlook for IT related companies, the current asset allocation reflects a less outspoken theme-driven shift of investments to this sector. The sustainability of the current long-term expected equity returns is high in comparison with the long-term economic growth potential and looks vulnerable when disappointments in the actual earnings development will occur. At the same time the competitive position of fixed rate instruments has improved.
As the table shows, it is not expected that the equity markets will repeat the stellar performance of last year but that it will be a year of consolidation of the equity markets.
Martijn Hes is senior equity strategy analyst at ING Investment Management Europe