Fund manager's comment/Chris Rice
The European economy seems to have stalled. Despite countries such as Spain and Ireland continuing to grow strongly, the largest economy, Germany, is still struggling to sustain growth 10 years after unification.
Inflation has surprised on the upside recently, predominantly because of higher-than-expected food prices with foot and mouth and BSE diseases. Despite this rise, we feel that inflation is still under control and anticipate that it will return to the 2% ECB target as food prices stabilise. The effect of higher energy prices will also fall out of the figures soon, further easing the headline data. This will allow the ECB to cut rates over the coming 12 months ' by up to 75 bp in our view.
Growth and corporate earnings and profitability remain uncertain. We believe German growth for this year will be little more than 1.0%, the lowest in the eurozone. Falling business confidence surveys in Germany and France support this view as the US and Asian slowdowns hurt exporters.
However, while the short-term economic picture is not great, the long-term reasons for looking to continental Europe remain in place. Furthermore, good fund managers will still be able to find companies that offer good value and can produce the goods even when times are more challenging.
One area that we feel offers value is cyclicals. Valuations still seem to indicate the market is not expecting much of a recovery in 2002. We are not so negative and expect to see a pick-up in earnings as we move through 2002.
In current market conditions, with earnings downgrades causing massive sell-offs, fund managers have to focus on avoiding the losers as much as picking the winners. In a market where earnings downgrades can lead to share price falls of 50% and more, two bad stocks in a portfolio can completely wipe out gains made in the rest of the portfolio. A stock-specific analysis is required to avoid these stocks but there are certainly areas where we could see more disappointments.
For example, we have been underweight in technology hardware and software sectors for some time. This year they are proving themselves to be as cyclical as the 'old economy' areas of the market. But with valuations in technology still up to four times that in the traditional cyclicals, we believe the risk-reward ratio still favours the old economy.
For this reason, we are not favouring highly rated sectors, preferring to concentrate in more 'value' areas. This cannot be at the expense of quality. For instance, we believe that the autos sector is particularly unattractive.
Over the coming months, the headline indices may make little headway. However, the underlying volatility at a stock level can be expected to continue, providing a fertile hunting ground for investors.
Consensus growth for 2002 too pessimistic.
Volatility provides opportunities.
Cyclicals to outperform.
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