Will tighter liquidity or a growth relapse mark the end of this positive economic phase?
Markets have been enjoying the most favourable phase of the economic cycle, in which growth is strong but liquidity conditions are still expansionary. The correct strategy has been to be overweight in higher-risk, economically-sensitive assets, preferring equities to bonds, cyclical stocks to defensive stocks, emerging markets to developed markets and lower-rated bonds to government securities.
The key issue this year will be when and how this benign phase ends. There are two main possibilities. A growth surge might produce inflation, necessitating higher interest rates - the tighter liquidity scenario. Or growth could disappoint as the effects of recent policy stimulus fade, renewing deflation concerns - the growth relapse scenario. The two scenarios have different investment implications. Tighter liquidity would be worse for bonds than equities. 'Carry trade" investments - such as higher-yielding corporate and emerging market bonds - would be particularly vulnerable. Among equities, defensive value areas such as energy might prosper while last year"s favourites - technology in particular - might under-perform.
A growth relapse would be worse for equities. Cyclical areas priced for sustained recovery - industrial, consumer cyclical and emerging market stocks - would probably fall while defensive growth sectors such as consumer staples and healthcare would outperform. The scenario would be nirvana for government bonds, but lower-rated corporate debt could under-perform as slower growth undercut profits.
In reality, the transition from the current benign phase may be some months away and tighter liquidity is more probable than a growth relapse. Accordingly, New Star"s institutional team continues to be overweight in equities, in particular in cyclical areas such as emerging markets. This is partly balanced by investments in defensive areas such as energy and healthcare, where relative valuations look attractive. As 2004 progresses, exposure to these areas is likely to increase at the expense of smaller stocks, which have outperformed but would be vulnerable in less favourable conditions.
The US is our most underweight market. The case for other markets was clear last year, with US relative valuations high and the dollar overvalued. Elsewhere we are modestly overweight in Europe and Japan. The Japanese managers doubt that the market is about to move significantly higher but are finding opportunities among second tier companies whose restructuring efforts are bearing fruit.
The largest overweight position is in emerging markets, particularly Asia. Valuations remain attractive despite recent out-performance. Previous bull phases such as- 1988-90 and 1993-94 - ended with the emerging markets price-to-book ratio matching or exceeding that for developed markets but there is still a 20% discount.
Fittingly in the year of the monkey, agility may be required for investment success in 2004. The economic and liquidity backdrop currently favours equities, but asset allocators need to be alert for early signs of a change in the environment.
MARK BEALE, DEPUTY CHIEF INVESTMENT OFFICER, NEW STAR ASSET MANAGEMENT
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