The latest economic releases suggest the aggressive monetary easing in the G7 has successfully engin...
The latest economic releases suggest the aggressive monetary easing in the G7 has successfully engineered an economic rebound on both sides of the Atlantic.
It is particularly noticeable that forward-looking economic indicators, such as the IFO survey in Germany and France's INSEE survey, have surprised on the upside. Although the high level of core inflation is a slight concern, we are relatively sanguine on the outlook going forward.
We expect headline inflation to fall in 2002 and likely surprise on the downside. Of course, as economic growth improves, the necessity for lower rates will be erased. We now expect no more rate cuts from the European Central Bank (ECB) and believe interest rates will begin to rise in the second half of 2002, possibly reaching 3.75% in a year's time.
That said, we expect there to be a meaningful hiatus between the time the Fed makes its first tightening move and the first upward move by the ECB.
Turning to portfolio positioning, we started to augment our exposure to early cyclicals in the final quarter of last year. Initially, we targeted companies in the paper, steel and building material sectors. These stocks have had a strong run as investors have become more confident about the prospects for the global economy.
We have started to take profits on some of these early cyclicals as we are mindful that they are unlikely to perform well in an environment of rising interest rates. The bulk of the proceeds of this move have been rolled into the media sector. Companies that will be the likely beneficiaries of the anticipated pick-up in the advertising cycle include Italian newspaper group L'espresso, free-to-air broadcaster TFI and advertising agency Publicis.
In terms of market cap bias, on a bottom-up basis, we continue to believe that the best opportunities are in the mid-cap, rather than the large-cap, area. We have identified a number of mid-caps that have been overlooked during the recent market rally and that remain significantly undervalued.
From a top-down perspective, the conditions are falling into place for European equities to make progress. We are at a turning point in the economic cycle, interest rates are low, monetary and fiscal policy are accommodating, and the yield curve is going up. These circumstances generally provide a supportive backdrop for equities.
However, there are some clouds on the horizon. It is particularly noticeable that some sectors, particularly higher beta areas such as telecoms and IT hardware, are trading at higher valuations than we would expect at this point in the economic cycle. While it is unlikely, notwithstanding any exogenous shock, that European equities will retest their September lows, I do not feel the economy or corporate earnings will recover as quickly as some expect.
Short-term uncertainty aside, the long-term case for investment in Europe, based on increased corporate restructuring and growing demand for equity assets from pension funds, is compelling. The fundamental undervaluation of the euro, while unlikely to be worked off soon, also augments the region's longer-term appeal.
Economic outlook improving.
Inflation does not threaten.
Plenty of mid-cap opportunities.
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