After three consecutive down years in equity markets, Schroders believes 2003 will be a better one for investors, despite current gloom, and we will look to add to our equity holdings as economic indicators improve. We expect gradual economic growth in 2003, although the pace is likely to be modest. Of course, the outcome of key factors such as the potential for war with Iraq cannot be predicted and short-term volatility could continue.
Our expectations for 2003 as a whole are that equity markets will provide positive returns. However, recent political and economic newsflow has deteriorated and in the near term any negative surprises could lead to a flight to safety by global investors.
Equity markets are fair value rather than cheap and are not priced to withstand any significant shocks. We are modestly reducing equity exposure to a small underweight. We will look to move back into equities as we come across attractive opportunities.
In bond markets, credit spreads have narrowed over the last few months and we have benefited from our overweight in corporate bonds. However, given the short-term risk of negative political newsflow, we believe that they have gone too far, too soon. We are reducing risk by adding to government bonds and cutting exposure to corporates and high risk bonds. Again, however, our view for 2003 remains unchanged. We are confident that company managers are becoming increasingly focused on addressing balance sheet concerns and this will support demand for corporate bonds this year. In this environment there is increased opportunity to add value through tactical asset allocation. We expect to move back into higher risk bonds as we identify opportunities.
We continue to maintain an overweight cash position in this mixed economic environment, although we will look to use this position to purchase equities as economic indicators improve.
Within equity markets, we are underweight US equities as valuations in the US are not especially attractive and we prefer regions such as Europe. While many US companies have cut costs, consumer support seems to be weakening and there are many uncertainties politically and diplomatically. There have been a number of disappointments from the US economy, where the recovery banked on by the rest of the world has lost momentum. Corporate America still shows the scars of a number of high profile accounting scandals last year and questions remain about corporate governance and accounting prudence, the dispute with Iraq and the impact on the oil price.
We are overweight Europe which has displayed higher beta characteristics in recent years and was one of the worst performing regions in 2002 in local currency terms. Valuations in Europe are attractive relative to other markets and historical averages. Although recent economic news has been uninspiring, we expect sentiment to improve on the back of recovery in 2003. The recent interest rate cut by the European Central Bank was welcome and with inflation subdued, more reductions could follow. If, as we expect, global equities perform better in 2003, European markets should be among the leaders.
However, we are modestly underweight in the UK as we believe that its defensive characteristics may hold the market back given our central view of a global equity rally in 2003.
Despite offering relatively good value, the Japanese market remains overshadowed by subdued global economic growth expectations. While the Japanese economy remains weak, there are still opportunities among undervalued companies. Many of Japan’s businesses have restructured and in the process have revealed significant hidden value.
Emerging markets offer good value both in relative and absolute terms. They are a beneficiary of economic recovery and are likely to outperform as a result of decreased risk aversion and rising bond yields. Investor sentiment has been improving and as signs of recovery emerge during 2003 this should continue, particularly as the political climate has improved in countries such as Turkey and Brazil. Many companies in emerging markets offer improved returns on equity and company managers are increasingly focused on rewarding shareholders. The prospect of delivering earnings growth next year remains high. Close attention to fundamentals allows these companies to be identified, and with good opportunities available we are positive on these markets.
The Pacific region should respond well to economic recovery and with valuations lower than in the West there are opportunities for the selective investor. We are overweight Pacific, excluding Japan and excluding Australia. We are not including Australia as its market behaves like western defensive sectors such as utilities and consumer staples and we expect it to lag given increasing evidence of investors’ appetite for risk.
Mark Pignatelli is chief investment officer at Schroders in London