Conditions right for cyclical upturn

BY Jonathan Arthur, manager of the Deutsche Managed Portfolio Fund

After a concerted recovery in the fourth quarter of 2001 equities have made a sluggish start to 2002. Despite improving macroeconomic news and positive sentiment on both sides of the Atlantic, investor appetite for equities remains subdued.

Concerns over accounting practices, increased equity issuance and the effects of FRS17 have all suppressed markets. There have been some exceptions however, such as the impressive performance of emerging markets and a recent rally in Japan.

On the whole, we remain cautiously optimistic about the prospects of financial assets in 2002 and bullish on stocks with our asset allocation funds overweight in selective equity markets. We believe conditions are in place for a cyclical upturn.

Liquidity is ample, growth is strong enough for modest profit expansion and there is enough slack for inflation to fall and interest rates to remain low.

We are overweight Europe, where markets have been outperforming the US since the lows of September and will continue to do so. European stocks are attractively valued and there is scope for the ECB to reduce interest rates as inflation falls. Across our European portfolios, we are looking for opportunities in cyclical stocks to tilt the balance from defensive sectors to more economically-sensitive ones.

While we feel that although UK returns may be ultimately limited by the large number of defensive stocks in the index, low valuations and a well placed economy mean attractive investments can be found. Valuation will prove to be the key, both in the case of stocks that are priced as distressed equity but will survive going forward, and stocks that will do well relative to their peers.

Our third overweight area is the emerging markets, which we believe are still attractive despite outperforming developed markets over the last three years. This was in spite of Argentina's problems, which have shown little sign of affecting the rest of the asset class. Although we have reduced our overweight position in this area, fundamentals remain strong and investment flows are starting to turn positive.

Exposure to both Asia and the US are broadly neutral to the index. Our concern in the US is largely one of valuation.

Responding to the ample liquidity and the increasing signs that economic recovery is on the way, the markets have priced in an aggressive bounce. In light of the head winds still faced by the US, we do not feel they offer good value.

Asian markets suffered during 2001 largely due to their considerable trade and investment links with the US and Japan. Towards the end of 2001, economic data showed signs of bottoming out and with liquidity conditions becoming favourable, Asia could well benefit from an upturn in the world economy.

We have recently reduced our underweight to Japan as the market seems to have priced in all the bad economic and company news and investors are focusing on looking for those companies that will be best placed to take advantage of an upturn in the global economy.

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