Reducing equities but buying Asia
Many feel that we could be now at a major turning point in the equity markets. Some argue that the strong performance since mid March shows that the equity market is going for a recovery in the economy. Some indicators indeed were quite positive, first quarter company earnings were in line with expectations and up from a year ago, and consumer sentiment even recovered. Others – and we rather belong to this camp – see the recovery in the context of the performance of a severely oversold market just some time ahead of a second Gulf War. Investors’ sentiment was at record lows and historically consistent with strong equity markets in the period to follow.
Stronger economic activity in the period after the Gulf War is still missing. If we exclude the apparently forever growing US housing market, not many of the indicators point upwards. In Europe the situation is even worse. A strong euro, the worsening situation in the labour market, investment activity limited by high overcapacity and slowing new orders make us revise downwards our European GDP growth forecast to 0.5% for this year and 1.5% for next year.
The only area with respectable economic growth is Asia. Although SARS has dampened GDP outlook in some countries (especially Taiwan and Hong Kong), recent abatement of the disease will limit damage to grow further. Economic activity in Asia will stay high. Although many countries highly depend on the economic state of China and the US, the internal growth is clearly improving. Recent exports jumped to 37%, boosted also by the weaker US$. Some Asian currencies are still pegged to the US$ (Chinese Rennin, Hong Kong Dollar and Malaysian Ringgit). The weak US$ but stable Asian currencies have supported the equity markets. Valuations in Asia are at very low levels, as they have been for two years now, and bond yields are at record lows as well. In some of the markets the bulk of the stocks are trading less than 10 times, trailing earnings with a dividend yield of over 4%-5%. We are overweighting this region in our global portfolios. On the other hand, we just started underweighting US, European and Swiss equities. Earnings expectations are still unrealistically high given the sluggish economic situation. Especially in Europe, the 30% consensus operating earnings growth will be hard to achieve. We expect downward revisions in the second half of this year. In Switzerland, the expected 110% earnings growth can be explained by the market domination of a few big companies, which are expected to produce positive earnings this year after having reported losses for last year. Even taking this basis effect into account, we soon expect earnings revisions, given the current recession of the Swiss economy. We remain underweighted in Swiss equities.
On sectors, we downgraded technology – not telecoms – and are generally focusing on lower beta sectors. For the coming months our global sector model gives us the highest expected returns in consumer staples, utilities and telecom, the lowest in energy and materials.
In bonds, government yields are on record lows and corporate bond spreads have tightened substantially. Comparing equity risk premia with credit spreads (see chart) we can see that, contrary to common wisdom, the bond market is currently less risk averse than the equity market. Usually, the two markets move together. Given our muted outlook for equities, equity risk premia are expected to remain high and credit spreads could therefore widen again.
Thomas Steinemann is chief investment officer at Vontobel Asset Management in Zurich