Equities remain overweighted vis-à-vis bonds in our portfolios, and the bulk of the equity portfolio is devoted to European shares. Investments are also being made on the US and Latin American markets, but Asia is still being avoided.
According to the most widely used valuation criteria, continental European markets, in particular, clearly remain undervalued, given the record low level of interest rates. With the advent of EMU, the euro bond yield could fall still further. This view is supported by three structural factors. First, on 1 January 1999, fragmented national markets will be replaced by a large and extremely liquid euro bond market , comparable in size and depth to its US counterpart. Even the differences in borrower quality seem to be narrowing more quickly than anyone could have expected. The fact that real interest rates in Germany have traditionally been higher than in the US can only be explained by factors relating to liquidity, and these are now disappearing. A second factor concerns the efforts to achieve balanced budgets within the euro zone. Now that the Maastricht criteria have been met, the stability pact will be used to oversee strict budgetary discipline. Lastly, the European Central Bank will pursue an unambiguous monetary policy, aimed exclusively at maintaining internal price stability. This will be a unique situation, because economic considerations still partly determine Fed policy in the US, while in Germany exchange rate stability has also always been an issue for the Bundesbank. Because the euro zone will be a more closed economic area, a more transparent and predictable monetary policy could serve to lower the risk premium.
We believe the European yield curve will flatten. Structural factors may push interest rates down further at the long end, though an increase at the short end is possible. This view is supported by economic factors (quickening growth in core countries, already buoyant economies in a number of countries) and by the creation of the ECB, which will want to establish its credibility from the start, which should be easier with tight monetary policy.
US company profits are already 60% up on the record highs set in 1989-90. In Europe, where they have only just equalled previous levels, the potential for increased earnings is huge. Economic growth, savings resulting from EMU and continued corporate retrenchment will help bolster profits and enable much of the leeway with the US to be made up.
Luk Van Heden is chief strategist with Kredietbank inBrussels