Financial markets constrained in aftermath of Iraq war
Since last summer we have anticipated that US military success in Iraq would be followed by continuing uncertainty. The effect would be both to produce buying opportunities when investors became unduly pessimistic and to constrain financial markets. This is the situation we find ourselves in today.
An issue we thought investors would have to face up to was the US economic outlook, since for quite some time we have forecast US GDP growth in 2003 of only 1.5%. Crucially, the excesses of the 1990s, although reduced, remain in the form of a large private sector financial deficit and the associated huge current account deficit. The UK economy, too, looks likely to slow rather more significantly than the consensus expects. However, encouragingly, forecasts are coming down towards our levels and in the case of continental Europe the economic community does not have a good word to say, so expectations are at rock bottom. At the same time, equity valuations have become more attractive. The UK and continental Europe look undervalued compared with the history of the past 10 years. On longer-term comparisons the picture is more contentious but using our equity risk premium analysis, Western equity markets are appealing in a post-1974/75 context.
Expectations for corporate earnings growth still remain too high, partly because of our more cautious economic outlook. Importantly, earnings forecasts will be reduced when option costs are expensed, continuing restructuring charges are no longer treated as exceptional items, and increased pension costs are included. Another restraint for equities is that large-scale buyers look thin on the ground. Pension funds and insurance companies are constrained for strategic or commercial reasons and retail investors usually follow rather than lead. This leaves M&A activity, which has been slow to pick up, with bids being mainly for equity rather than cash. All in all, we think this adds up to an active approach to equity allocation around a modestly overweight stance.
In terms of regional equity preferences, we have increased our exposure to the Far East (ex Japan). Strong growth in the Chinese economy will benefit other countries in the region. Other attractions here are domestic demand, which is inherently stronger than in developed economies and valuations that are attractive both historically and compared to other regions. The lowest valuations are to be found in the UK, which we continue to overweight, although the dynamics will deteriorate as the UK economy will still be slowing when other economies start to accelerate. In contrast, US valuations are demanding, even allowing for the superior growth prospects of US firms. Japan remains a conundrum: bottom-up the corporate sector is doing its best to improve profitability but top-down reform is sadly lacking.
Sectorally, we have moved overweight in the energy sector which had performed poorly despite the oil price remaining at elevated levels. Among the sectors we are underweight, consumer cyclicals such as retailers are liable to suffer as consumers bring their spending patterns down to more sustainable levels.
Colin Robertson is a global strategist, Threadneedle Investments
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