Fund manager's comment/Jonathan Arthur
We have been bullish since the third quarter of 2000, when we moved into an overweight equities position versus bonds. Although subsequent equity movements meant that performance suffered, we still believe that the underlying fundamentals are sound.
Recent weakness in the equity markets was caused by the dramatic decline in profit expectations. Three quarters ago, the consensus 2001 earnings growth expectation for world equities (and for technology stocks) was 15%. Overall profit expectation is now 0% and continues to fall.
The second quarter of the year saw a bounce in markets fuelled by cheap valuations and aggressive rate cuts. Markets are locked between the positive of liquidity and the negative of continued concerns about corporate earnings. By the end of 2001, we believe equities will have recovered and should end the year on a positive note. This view has been bolstered by a recent turn in profit downgrades and other leading indicators.
The UK remains unattractive on a global basis. As the markets recover, it will underperform because of the number of defensive stocks in the index. The market is heavy in financials, pharmaceuticals and energy firms ' none of which are prime beneficiaries of falling energy prices and improving global growth expectations. Uncertainty surrounding UK entry into the euro will also have an effect, with sterling and interest rates coming under pressure.
We still remain overweight in the US and believe the background for equity performance is improving. On a rolling 12-month forward basis, the consensus level of expected S&P 500 profits has stabilised and should be start to rise again by the end of the third quarter.
Monetary easing cycles also tend to expand market valuations. A combination of higher earnings multiples and stable-to-higher levels of profits will be good for US equity returns.
We are also overweight Europe and believe a lot of bad news has already been priced into valuations. It will take a few months for confidence to return and we do not envisage any meaningful upturn with low risk before the fourth quarter of the year.
Over the last quarter, we have reduced our exposure to Japan. As with the UK, we believe that performance of the Japanese stock market will be poor compared with other markets. Japan's markets will also be affected by an inability to respond to economic weakness. Unlike Europe, where a rapid slowdown has also occurred, Japan does not have sufficient monetary or fiscal flexibility to respond.
Overall, we have remained modestly overweight equities versus bonds and, since the second quarter, our overweight position has begun to outperform. We have added to our equity positions in the emerging markets and reduced exposure to Japan. We continue to be overweight European and US equities and underweight in the UK.
• Bad points already priced into market.
• Leading indicators beginning to turn up.
• Downward spiral of earnings downgrades.
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