Unweighting fixed income logical
The scenario of a pick-up in growth, contained inflation and ample market liquidity suggest a continuation of the trends seen in recent months for financial markets and a preference for equities, particularly high risk markets, over bonds. We can also expect to see greater risks in the second half of the year than in the first half: risk of monetary tightening, growing concerns about inflation, gradual loss of momentum for corporate earnings and the impending presidential elections in the US, which may have a significant impact on world trade.
Geographically, we are most confident about the emerging markets, which benefit from strong growth, a weak dollar and low interest rates, rising raw material prices and a revival of investor risk appetite. The Chinese authorities’ struggle to prevent overheating presents a real threat to the asset class though we believe that the risk of contagion is low. Indeed, if there is a sharp slowdown, markets such as Korea, India and South East Asia are likely to perform favourably. Japan also represents a possible trump card – despite investor scepticism, there has been spectacular progress made by several Japanese industrials and improvements in the financial sector are underway.
In terms of sectors, 2003 was the year of cyclical industrial sectors, including technology and financial stocks. This trend could also persist in the short term, if liquidity and risk appetite remain strong. The relative attraction of cyclical sectors is nevertheless less clear in terms of valuation; technology stocks are clearly expensive ; they have been dependent on a upwards earnings trend and once a rise in interest rates is anticipated, we can expect a switch towards more defensive sectors. Healthcare and telecoms would then be favoured.
This globally positive scenario, at least in the short term, nevertheless includes a certain number of risks. First, how far can the dollar drop? The dollar’s depreciation against the euro has been particularly pronounced over the past three years, exceeding all forecasts and representing a source of risk for the earnings of European companies. If we take as a reference the last major depreciation of the dollar during the period 1993-1995, when the dollar reached 80 Yen and DM1.35 (equal to almost US$/E1.50), the euro is still only modestly overvalued. In 2004, a deliberately expansionary US economic policy, deep external imbalances and a protective trade policy in the run-up to elections, all suggest that recent trends will continue at least until we see a monetary tightening in the US. Experience shows that very pronounced trends on the foreign exchange markets generally mean vulnerability on the equity markets. As such, in terms of asset allocation we intend to limit exposure to the US dollar and maintain a bias towards European equities.
Will China, which contributed significantly to the increase in demand for raw materials and strong international trade in 2003, see a hard landing ? The growth of industrial activity in China would appear to be unsustainable and there are signs of an acceleration in inflation, though measures taken by the authorities to increase statutory reserves and to encourage capital outflows to halt monetary growth are starting to show. We do not believe there will be a revaluation of the yuan on the back of US pressure: this would only have a temporary effect on monetary trends and would represent a shock for all international markets. The most probable scenario therefore is that there will be gradual and moderate monetary tightening, leading to a soft landing for the Chinese economy in 2004.
As we are aware, the main risks for the equity markets traditionally lie in interest rate trends. The initiation of a phase of monetary tightening would undoubtedly have a negative effect on financial markets, particularly since current equity market valuations are only sustainable because of relatively low interest rates. Although the bond markets performed quite well in 2003, the risk that 1994-style turbulence will be repeated cannot be ruled out. However, there are several differences this time round: firstly, low short rates will limit the risk of a rise at the long end of the curve. Secondly, the 1994 bond market crash was accentuated by a high level of speculation on European convergence. Conversely, sentiment today regarding the fixed-income markets is extremely cautious, therefore we do not expect to see a significant correction. However, we do believe it logical to underweight fixed-income assets in a scenario of persistently rising equity markets underpinned by liquidity flows. Once central banks have taken a definite step towards monetary tightening and the climate on the bond markets has clearly deteriorated, a reallocation towards lower risk assets should then be on the cards.
Eric Tazé-Bernard is chief investment officer multi-management at INVESCO in Paris