Recent economic indicators tend to confirm our macroeconomic scenario for the US. In the second quarter of 2002 at the latest – that is, when the inventory correction has ended – positive growth figures will be recorded once more. The Fed’s aggressive interest rate policy, the fiscal incentives packages and the fall in oil prices will undoubtedly contribute to the economic recovery. However, it will be some quarters before economic growth again rises above the long-term trend of 2.5%. Higher unemployment (there is always a time lag before job creation reacts to an economic upturn) and only moderate rises in income limit the potential for growth in private consumption. In addition, the low level of the capacity utilisation in industry curbs the dynamics of business investment.
In Europe too, the confidence indicators are improving. Europe will again follow the US cycle. This is not true of Japan, which is still struggling with deflation.
Inflation is not an issue. Therefore, both the Fed and the ECB are able to continue their policy of monetary easing. We are working on the assumption that in the coming weeks the Fed will take just one last step in cutting the interest rate. Certainly, as soon as European inflation amounts to less than 2%, the ECB will also have scope to cut the euro money market interest rate further. Interest rate cuts will however be carried out very cautiously, because not all the monetary policy warning lights are green.
The risk of a rise in bond yields is distinctly higher and is certainly greater than the chance of a further fall. Traditionally, the low of the interest rate cycle more or less coincides with the low of the economic cycle and this turning point is close at hand. In addition, attention may turn more in the future to the deteriorating state of government finances. The US federal budget will close the financial year with its first deficit in many years. However, there is no reason to fear a strong surge in interest rates. The inflation outlook is too favourable for this and the expected acceleration of growth too modest. The European bond yield will continue to follow the developments on the US market.
For the next three months, we are working on the assumption of an expected yield from the equities markets that, although lower than the historic mean, will be distinctly higher than that from bonds (slightly negative, on account of the expected interest rate rise). On the basis of fundamental valuation criteria (such as the earnings/ bond yield ratio and the risk premium), the traditional equity markets are to be termed cheap. This undervaluation is, however, counterbalanced by the fact that the rate of profit adjustment is still very negative. It is clear that the accepted profit expectations of analysts and market participants are still entirely under the spell of a persistent recession scenario. We do not accept this scenario. It can therefore be assumed that in the coming months, the consensus expectations will be revised upwards at a rapid rate.
This is why we are boosting the equities position in our portfolio (see table). The duration of the bond portfolio is reduced. By overweighting corporate bonds in preference to government paper, the marked pro-cyclical allocation is clearly extended to the bond portfolio.
In the regional allocation of the equities portfolio, the most important position is the underweighting of Japan. In contrast to the other regions, there is no question here of (prospects of) an economic recovery. The lack of a vigorous policy and the weakening of the yen are additional factors which undermine investment confidence. This underweighting is offset by an overweighting of the US and Europe, both more or less to the same extent.
In the sectoral allocation (see chart), our preference is for the high beta sectors, technology and cyclical sectors. In terms of relative valuation, the premium for technology is now lower than the historic mean, even if the bubble of 1998–2000 is ‘eliminated’ from the comparison. This is particularly true of US technology. The overweighting of the cyclical sectors is located chiefly among the early-cyclical basic goods and the relatively cheaply valued capital goods. Energy is underweighted because of the unfavourable prospects for oil prices. Finally, the financial sectors are also overweighted. Here, the emphasis is not placed on the (interest rate-sensitive) banks, but on the specialised financial institutions (including, for example, the investment bankers, the bulk of whose income comes from business-related commissions and fees). The beta of the portfolio, which we calculate at 1.03, is also created by the underweighting of the ultra-defensive utilities and consumer staples.
Luk van Heden is chief strategist with KBC Asset Management in Brussels

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