As the international markets settle into the new year, we find out what fund managers are predicting for 2002 and name the companies to look out for in the major markets across the world
At the beginning of last year, interest rate cuts made cyclicals a clear investment theme, but earnings disappointments meant that, by April, a more defensive approach had come to the fore. The impact of 11 September and the accelerated monetary easing that followed returned the focus to cyclicals once more.
Mike Felton, manager of the RSA Equity fund, says the hope is that the second quarter of this year will see a stabilisation in earnings. 'This will provide the market with a greater investible universe of stocks,' he says. 'but it will depend on the extent of any discounting among the market's better quality names.'
Market volatility was intense throughout 2001 but liquidity improved strongly as a result of ongoing interest rate cuts ' which provided a natural buoy to equity prices.
Felton adds: 'We see good value in the market as a whole and expect this to continue into 2002, although some high beta, financially distressed technology stocks are very expensive. At this point, we see the most value in mid- and small-cap companies, particularly cyclicals, and expect this trend to continue for the foreseeable future.'
Felton gives Man Group as an example of a company that has been able to make the most of recent conditions ' as a firm dealing in hedge funds, Man has thrived in the UK's recent volatility. Although he sees some indications of stabilisation towards the middle of next year, volatile times are here to stay so he expects the company to continue to prosper.
Exel is another company that has rewarded us in the last year, but one that we see as being perfectly positioned to benefit from the anticipated upturn in global growth next year.
Despite the attractions, the UK has also seen its share of casualties this year, according to Felton. 'Sainsburys is a good example,' he says. 'It has struggled this year as a result of the hardening fundamentals in the food retail market, and is likely to struggle in 2002, with the market being more attracted to cyclicals than defensive stocks.'
M&S is another high-profile example. 'The company has been performing well and made some easy gains,' says Felton, 'but we now see it as being at the tail-end of its recovery. Further progress will be increasingly difficult though, as interest rates begin to rise and the economic environment moves further against them. Looking out over the next few months, we do not expect significant further rate cuts and expect the MPC to be the first to take back some of the recent cuts.'
Over the course of last year, market malaise has forced fund managers to maintain rigorous self-discipline. Meanwhile, as is typical of a bear market, very few investors have actually benefited from taking active risk.
Tim Sharman, a US fund manager at RSA says: 'Until very recently, recent months had been a one-way ticket for US technology stocks. Valuations here have struggled against retrenching IT spend and the fact that many investors have sought to reduce concentrations of high p/e stocks.'
'Precarious market conditions compounded further following 11 September and it is fair to say that identifying a clear investment theme has been next to impossible. As a result, a significant amount of sector rotation has been taking place and this is likely to continue during 2002.
Meanwhile, interest rates have been supportive to the US market, but indications suggest that the trend is now almost over. Despite this, there may be some cause for optimism ' although the US is officially in recession, record levels of fiscal and monetary stimulus will aid recovery and we expect positive signs as early as the second quarter of 2002.
Elsewhere in the US, the retail market has seen a distinct migration from equity to fixed-income and money markets. The current monetary and fiscal stimulus continues to find its way into financial assets and should continue to do so during 2002.
In terms of the market, Sharman explains that there has been a significant increase in stock repurchase and buy-backs, with M&A activity almost drying up. During 2002, he believes the important drivers will be revenue and earning growth rather than p/e and that equities should offer fair value against bonds.
In terms of stocks to look out for in the coming year, Sharman sees a mix of defensives and cyclicals as the most promising opportunities. 'We are interested in cyclicals where the share price is likely to rise as well as those companies with potential mergers on the horizon,' he says. 'In terms of technology, we will be cautious but as the rally has pushed some tech companies up 100%, the outlook for the tech sector is improving.'
According to Davina Curling, European fund manager at RSA Investments, the uncertainty that followed the events of 11 September triggered new waves of market volatility in what were already erratic European markets.
'At the corporate level,' she says, 'stocks have risen since 21 September despite some negative newsflow. This suggests that the market seems better able to shoulder bad news, even though we expect to see market volatility continue at its current high levels for some time to come.'
The lead for the European market rally came from US monetary policy, which saw rates cut more aggressively than in Europe. Business and consumer sentiment did take a serious knock following the attacks, though by less than in the US, with damage concentrated to service related sectors.
'In fact, the lower interest rates and oil prices, along with swift progress in Afghanistan encouraged investors to disregard bad news in the short-term and look to a recovery this year,' says Curling. 'High-beta, long-duration sectors such as technology, media and telecoms and capital goods were the beneficiaries of this, while highly indebted stocks, which seemed in danger of failing a few months ago, have also bounced back strongly.
'The promise of further disposals and more cost-conscious management was sufficient to see stocks such as KPN and Sonera double their share price and their equity capital in rights issues. Meanwhile, sectors such as oil and traditional defensives like pharmaceuticals, utilities and food all struggled.'
Looking out into 2002, although we took some profits late last year, we remain overweight in selected cyclicals such as DSM (chemicals), Thompson Multimedia (media), Renault (autos) and Lufthansa (airlines).
Curling says the house has remained underweight in the banking sector, in which Spanish banks, with their Latin American exposure, are a particular problem area. She does hold investment banks such as CS Group and BNP Paribas however because of their strong cyclical positioning.
'Inflated valuations will also keep us underweight in defensives for the time being,' she adds, 'and the same is also true of IT hardware. Although we benefited from our overweight position in that sector at the end of last year, we currently prefer software companies. We are maintaining an overweight position there as we see software as offering better value in the year ahead while operating conditions remain tough for hardware operators.'
With sector calls likely to remain difficult this year, the focus will remain on stockpicking, with restructuring one of the key themes in Europe. Ongoing tax reforms in Germany, for example, offer good restructuring potential, particularly in the case of stocks like Karstadtquelle (retailer), Allianz and Munich Re.
Markets in the Far East benefited last year from the US rate cutting, easing the impact of an economic slowdown and suggesting a recovery later in the year.
'As a result,' says Mike Hanbury-Williams, manager of the RSA Far East and Pacific Growth funds, 'the last year saw a balancing act between policy easing and optimism within the market with not a little anxiety over a delay in recovery.' With market volatility so high, it has been a difficult year for investors seeking worthwhile growth opportunities. Indeed, with the most recent market rally having been driven largely by liquidity, we expect such rallies to come and go as investors choose to believe and disbelieve that the next growth spurt is under way. This trend is likely to continue into next year but with an underlying improvement and signs of a recovery towards the end of next year.
'Market volatility has seen stock movements of more than 25%, both up and down, in the region, with Korea being among the most volatile markets in the entire region,' says Hanbury-Williams. 'As a result, market anxiety is likely to endure for some time, making valuations for next year difficult to project.'
However, we expect relative valuations to be cheap compared with the US ' Asian markets have traditionally outperformed the US ' while attractive valuations in 2002 should boost equity performance.
Going forward, we expect a clearer divide between defensive, low-risk opportunities and high-risk/higher growth options, with a decreasing middle ground, long fundamental to the investment process.
Samsung, for example, provides a good illustration of recent trends in the Far East. 'As a high beta stock,' explains Hanbury-Williams, 'Samsung has experienced a continuous yo-yo effect throughout 2001, with price gains and reductions stimulated by market sentiment. We expect the company to continue this trend throughout 2002 and, in doing so, provide steady future growth as market liquidity continues to drive the beta play up next year.'
Fosters meanwhile, probably demonstrates the other side of the coin ' it is a relatively low-risk company that has experienced less volatility due to managers erring on the side of caution. We see the brewer as likely to continue to provide a secure holding and steady earnings growth next year, as one of the few stocks likely to retain its value into 2002.
The key theme in Japan has been one of economic slowdown, says Ben Williams, a Japanese fund manager at RSA Investments. 'This has been largely accelerated by corporate inventory corrections,' he says, 'but we expect to see a reversal of this in 2002 stimulated by an increase in demand.'
Japan is currently in a consolidation phase ' particularly for industrial production. Despite the events of 11 September, we feel foundations are being laid that will enable a market drive in 2002.
'Liquidity has been relatively low compared with other overseas equity markets,' explains Williams, 'but Japan, being a highly operational region, is naturally geared towards earnings, making valuations the cheapest they have been for two decades.'
But the Japanese economy is still so feeble that interest rates remain at 0% and are likely to remain so for the foreseeable future. We expect to see industrial production become a key factor in market growth this year as our analysis of the inventory cycle and peak to trough calculations indicate an improvement from at least the middle of 2002. However, this improvement is likely to be gradual. We also expect an improvement in technology stocks as inventory levels and orders improve. 'The improvement so far for component and semiconductor companies has been restrained,' says Williams, 'but it will gradually feed through to higher production and capacity utilisation.'
Sumitomo Bakelite, a Japanese manufacturer of semiconductor sealant, illustrates this trend. Shipments have increased in recent months but as its product is difficult to store, the figures are a good indicator of rising demand. The same story is true of other component companies, demonstrating that the inventory correction is drawing to an end.
While valuations should improve in 2002, we expect the market to need some serious persuading. It is unlikely that valuations will drive the market but, at the same time, they will not stand in the way of a potential rally. 'Deflation, however, is becoming more of a problem in Japan,' says Williams, 'and is putting severe pressure on the economy.'
Daiei, a supermarket, is a good example of how this pressure has injured corporates. Here, a heavy debt burden and the inability to raise prices meant that the share price had only one place to go.
Companies that have succeeded despite market difficulties include K O Electric Railway. But its progress is more a result of investors seeking the refuge of stable companies with large cash flows. We believe that this trend has now run its course, and investors will again target more obvious growth opportunities.
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