Equity markets have been in a bear market place since July 21. The duration of bear markets has contracted as a result of faster flow of information and we are focused on just what has and what has not been discounted in the market. Risk premiums have been turned on their head.
We recommended that institutional clients with long duration liabilities who have been altering their equity/ bond mix towards fixed income should now selectively engage in stock picking. The flight to quality has created some surprising valuation anomalies. Short duration funds should remain with their current de-fensive allocation towards bonds against their benchmark weight.
The reasons for current market sentiment is well documented namely contagion and a process of competitive devaluation. It is our contention that Europe is well positioned to weather a global recession. The personal balance sheet of the European consumer is in better shape than those in the third world or even the US.
We acknowledge that the risk premium has risen substantially but we do not see an immediate return to previous levels as these failed to take into account the systematic risk that has arisen as a result of globalisation. That said, the benchmark 30-year US Treasury is trading below 5% for the first time in living memory. If the yield falls further it is unlikely that risk premiums will continue to increase. This scenario would only appear sustainable in the long run if we are facing a global financial meltdown. We feel such a gloomy prospect is too pessimistic.
Over the next quarter, the US and European economies will have to ab-sorb production from the third world and this will dampen earnings. Analysts' expectations are still too focused on top-down growth projections in these markets and as such we may see further downgrades.
The flight to quality has been indiscriminate and as a result many companies offer unique buying opportunities despite the overall trend in the market. Within Europe, we have seen no major sector or country effect, just a systematic sell-off. Even within the banking sector, re-rating has been largely biased towards international rather than domestic banks.
The market is overlooking news previously considered favourable. The inflation rate in the 11 start-up members of European economic and monetary union (Emu) dipped. Earnings growth in such an environment will deliver a real rate of return higher than bonds. Despite lower inflation, real GDP growth has been generally lower in core Europe than the OECD in general. The European consumer has not been consuming as aggressively as those in the rest of the OECD so there is pent-up demand.
Daniel Broby is chief portfolio manager at Unibank in Copenhagen