The economic recovery is broadening. The US and Asia remain the two engines while the Euroland is accelerating even if it is still lagging. Profit margins keep on rising in the US and Japan. It is bottoming in Euroland but some improvements are expected. So far, the profit cycle is well oriented and the analysts are still upgrading their estimates. However, the case for an economic slowdown during the second half of the year remains strong. We are overweight equities, underweight bonds (slightly) and cash.Our equity allocations are rather cyclical, but this bias has been reduced and could become more defensive if our economic slowdown scenario should become more probable. In this context, the main risk on equity markets rely on a sharp dollar collapse. However, should the dollar depreciate versus the euro and yen, it should be gradual.
As far as equity markets are concerned, we remain positive on their future prospects.
In term of geographical allocation, we have preferred emerging markets for a long time and we still do. Our top picks are Brazil in Latin America, South Korea in Asia and Russia in eastern Europe. The reasons can vary, but one common factor is cheap valuation and growth potential. Brazil has improving economic fundamentals, Russia has restruction potential along with its solid oil companies. South Korea is attractive, thanks to its obvious links with the rest of Asia and its performing companies, as well as good prospects for its domestic consumption.
Our second choice is Japan, although we slightly reduced our overweight position due to cyclical considerations. The country is clearly benefiting from the rest of Asia’s dynamism, which leads to accelerating private investments after years of slowdown. The Japanese economy has been the biggest surprise in 2003 and it could continue to be better than expected. It appears too early to believe that the Japanese structural problems are behind, but they are improving.
We are more positive on Euroland compared to the US. In addition to more attractive valuations for most of ratios (PER, PCFR, EV/ EBITDA), it seems that, in the current part of the cycle, the potential for positive surprises (both on macro or micro-economy) is higher in continental Europe than in US where expectations are already high.
We remain in favour of cyclical sectors like materials, industrials or consumer cyclicals. However, we are reducing our overweight positions as those sectors tend to under-perform a few months after leading indicators peaked out. But we maintain our slight overweight exposure on technology as the earning dynamic outpaces the stretched valuation. This is done at the expense of defensive sectors like staples and utilities (but we have recently increased our weighting on health-care due to valuation considerations). We are also underweight in financial stocks as we have some questionmarks on the sustainability of their good results.
On the bonds markets, the risks are still on the downside. Long term interest rates in the US and in Europe are still waiting for a signal coming from the Federal Reserve. For the time being, the central bank is talking about “patience” and is highlighting the weak job market in the US as a good reason to stay neutral. However, employment is likely to improve somewhat in the coming months, knowing that productivity tends to be very strong at the beginning of a recovery before fading. Thus, we don’t rule out a Fed tightening before the year end but we don’t believe it will have dramatic implications on the bond markets if the US slows down during the second half of the year. Bonds provide a partial hedge on a diversified portfolio when the main active risk is on equities and that is why cash, and not bonds, is strongly underweight in our portfolios, despite our slightly bearish view on the bond markets. Indexed-links bonds remain overweight in the portfolio. Their valuations are not attractive anymore, but it could benefit from the great success of this new asset class in Europe and from the risk of rising inflation expectations in this context of recovery. On investment grade and the high yield markets, positions are more neutral as the spreads are quite tight, knowing that the risk reward is now clearly on the equities. Thanks to the low level of the implied volatility on equities, the convertible bonds are overweight. Emerging markets bonds are underweight, due to the tightness of the spreads and the risk of monetary tightening in the US.
Benjamin Melman is chief strategist at Crédit Agricole Asset Management and Crédit Lyonnais Asset Management in Paris