Asset liability studies for our Swedish institutional clients often result in an average strategical asset allocation of 50% fixed income and 50% equities. Taking into account the equity and currency risks, along with the possibility for diversification, the typical equity portfolio is usually split equally between Swedish and international equities. However, on the fixed income side, Swedish institutions tend to focus on krona-denominated securities.
In our opinion, the world economy will continue to show attractive growth numbers during 2000. As a result, we expect somewhat higher bond yields. Central banks will tighten monetary policy in an attempt to stem inflationary expectations.
Japan is an exception. Here we expect growth to be below the world average, even though the 2000 GDP numbers will be an improvement on previous years. Therefore, the Bank of Japan is likely to stay with a loose monetary policy, as it tries to restore the strength of the banking system.
Our clients’ portfolios are now neutrally weighted between bonds and equities. Given current valuation levels, the expected return calculations are not high enough to motivate a more aggressive stance, at the same time as liquidity growth is slowing. We define liquidity growth as combination of monetary indicators growth less nominal GDP growth. In the US and UK, this number is now below historical average, while it is down from recent highs for Europe and Asia but still above historical averages for those financial markets.
Why, then, do we not underweight equities? The reason is that growth estimates for GDP, as well as for company earnings, are still being revised upwards, which creates a positive environment for equities.
Currently we work with an average duration at 3.5 in the fixed income part of our clients’ portfolios, which is in line with the benchmark. The yield differential is still large enough to motivate concentration on krona-denominated bonds, even taking into account the benefits of risk diversification that investing in other currencies would mean.
At the time of writing, we split the equity part evenly between Swedish and international stocks. Our expected return calculation indicates that any deviation from the strategic benchmark should be limited. On the positive side, the Swedish liquidity situation is better than the world average, at the same time as earnings revisions are somewhat stronger. On the negative side, we see a risk for large divestments of Swedish equities in favour of Euro-based equities, as Swedish institutions adjust their portfolios to an expected Swedish entry into EMU.
A change on the liability side from Swedish krona to euro makes it irrational for institutions to stay with large Swedish equity holdings, that on average entail a higher risk than the euro average.
This transformation process has just started, but may pick up speed now as a single company, telecom and mobile phone producer Ericsson, after doubling its market value in the last quarter represents almost 30% of the Swedish benchmark.
Within the international equity our favoured regions are Europe and Japan, while we underweight the US and keep the Far East on neutral. Europe offers the highest expected return in our forecasts, even when we take somewhat higher bond yields into the calculation. We see Japan as having the best liquidity and earnings revisions situation. But since a large part of last year’s foreign buying to close underweight positions is over, it will take clear evidence of positive effects on corporate earnings from industrial restructuring and an improved domestic economy, to realise the potential we see in the Japanese equity market.
Given today’s strained valuation levels, our forecasts of good earnings growth and unchanged bond yields still make the US equity market less attractive. The US offers the lowest expected return and the worst liquidity situation. Add to this that expected earnings revisions are only in line with the world average.
For the Far East, we maintain our positive outlook on the economies, but after the very strong performance in 1999, we only see a stock market potential in line with the world average. Both earnings revisions and the current liquidity situation are better than the world average. However, the pressure from new equity issuance is mounting, as many companies and governments try to improve their balance sheets.
On a sector basis, our clients’ portfolios have the largest overweight positions in telecom operators and energy, while consumer staples and financials are the largest underweight. The weight in IT has been reduced to a slight underweight, after last year’s exceptionally strong performance. We still have a positive view on future growth for the sector, but with current valuations expectations have been set very high.
Jan Hillerström is senior portfolio manager and global strategist with SEB Investment Management in Stockholm