Doubts about the sustainability of the economic expansion do not seen to have been banished. The US labour-market situation remains precarious and the continuing high level of crude oil is grist to the mill of the economic pessimists. We expect the slowdown phase is set to last until mid-2005 (with a growth rate of 2.5-3%). In the somewhat longer term we foresee economic growth to be sound. Monetary policy is generally still quite expansive (except in the UK). Fiscal policy in the US is expected to be tightened in fiscal year 2005-2006, at the earliest. In Europe, too, there is little willingness to raise rates. Job creation will continue to underpin household consumption in the US and the consumer will be the main driver for economic expansion in Europe, too.
The Fed is expected to push ahead with the normalisation of its key rate in ‘measured steps’. Given the low level of inflation (despite rising oil prices), there is no urgent need to pursue an aggressive policy. It will probably raise the fed funds rate to 2.25% by mid-2005 and to 3% by the end of the year. Hence, in the short term, bond yields are likely to continue to fluctuate around current levels.
Stock markets are still - unjustifiably - dominated by economic pessimism. This means that valuations have remained extremely low. However, the high risk premium on shares does not seem to be an expression of general risk aversion, attributable to factors outside the system (terrorism etc), but rather to uncertainty about the economic cycle. In other financial market segments (corporate bonds, emerging markets, etc), the risk parameters have slipped to exceptionally (record) low levels. Once the economic doubts recede, the markets should start showing interest in these high risk premiums, eliminating the undervaluation and focusing on earnings growth. Consensus expectations for the 12 months ahead are still for earnings to increase by 10% (US) to 15% (EMU).
We expect that over the next three to six months, the bond yield will remain more or less stable, but the risk is at the upside. Opting for overly long maturities renders our portfolio too sensitive to that risk and the choice of overly short maturities means sacrificing some of the yield. The duration of the bond portfolio is equal to the bench.
Corporate bonds are underweighted. Credit spreads have already fallen steeply to historical lows. This reflects the better economic climate and the improvement in many companies’ financial structure. The low credit spreads have considerably increased the advantages of this funding technique compared with standard bank loans.
The overall currency risk is underweighted, due to the underweighting of the dollar and the yen. Significant active positions have been taken in a number of central European currencies (PLN, SKK and CZK). With these positions our policy is exploiting the region’s convergence with the EMU. This process is not without its hiccups and, as a consequence, bond yields still offer attractive risk premiums and investing in several currencies is advised. In 2003 and 2004, macroeconomic policy was not uniformly orthodox. The bond yield spread with the EMU is expected to stabilise (Czech Republic and Slovakia) or narrow (Poland) in the months ahead. Inflation has passed its peak in Poland, and there is no need for the central bank to continue with its tight monetary policy. We are avoiding
the Hungarian forint for the time being, as the twin deficit is a cause for concern.
The high correlations between the US and European equity markets and between the various European markets themselves makes it difficult to discriminate between them. The fundamental developments are also very similar. There are signs of a good earnings trend in both regions, and they are all just as severely undervalued.
We are not taking an active position in Japan either. The uncertainty surrounding the economy and the future of the Koizumi government’s reform policy is too great. We have a position of 1.25% in the emerging markets of Southeast Asia, thanks to the favourable valuation and generally healthy economic fundamentals.
Healthcare is the sector par excellence which combines the characteristics of a growth sector with a defensive bias. Pharmaceuticals are particularly attractive in times of economic uncertainty, since turnover and earnings growth are structural in nature, and not linked to the economic cycle. Recent company specific problems, mostly in the juridical sphere (Merck, Pfizer, Chiron, AstraZeneca) influenced negatively the valuation of the whole sector and created a lot of opportunities.
Information technology is being burdened - unjustly in our opinion - by considerable uncertainty. US software companies have released excellent results and orders are increasing. The trend towards consolidation is an additional significant factor. Companies are increasingly inclined to place orders with just a few of the
larger players, which encourages rationalisation of the market and a wave of consolidation (takeovers). Microsoft, Oracle, Computer Associates and Symantec appear to be
the winners.
Traditionally cyclical sectors - materials and industrials - are underweighted. The slowdown phase and persisting doubts about the sustainability of a possible economic recovery are creating anything but a favourable climate. We are avoiding the mining sector on account of the expensive price of shares and the less favourable outlook for ore prices. On the other hand, the chemicals sector continues to struggle with high oil prices. In the capital goods sector, we are underweighting defence (the US budgets have hit record levels) and aircraft manufacturing (there is still surplus capacity in the aviation segment, despite recent improved trends).
Luc Van Heden is chief strategist at KBC Asset Management in Brussels