Less exciting times ahead, but a gradual return to equities likely
Western equity markets have now risen from their mid-March trough and are close to our current market estimates of fair value. While bond yields have risen from the low levels reached in March, we expect them to rise further in coming months, and for the time being are holding the proceeds in cash. Forthcoming equity market retrenchment could offer an opportunity to re-enter stocks or, alternatively, a rise in bond yields would make fixed income more attractive than cash.
We maintain the view that equities will outperform bonds in 2003. A return to the stellar rewards from equity markets seen in the TMT/dotcom boom of the late 90s is not expected, although periodic rallies of 20% or more are still likely to occur. A period of less exciting equity market returns from buy-and-hold strategies is probable. Nevertheless, we expect investors to gradually realise that equities do offer more positive prospects in the long term and begin to increase their risk appetite.
In the UK, current sentiment among investors is generally anti-equity, as they seek the security provided by fixed income assets. However, the yields on these assets have fallen to secular low levels. The main measure of inflation has risen slightly recently to 3%, meaning the real yields on gilts are extremely low, around 1-1.5% lower than the long-term average. Even if inflation falls back to its target level or below (a fall of about 0.5-1%), and there was a return to average real yields, nominal yields would need to rise by about 0.5-1%. Such a rise in nominal yields over a 6-12 month period would result in a near zero return for gilts. The additional amount of bond issuance that the government will need to undertake will only add to the supply side of the equation.
Turning to the US, companies have recently successfully been beating profits estimates but the sustainability of double-digit earnings growth is questionable. Relative to its own history, the US equity market is not cheap, though it looks more reasonable when compared with bonds.
In Europe, markets are boosted by their more attractive valuation but the projection for underlying profits is not good. We would expect nominal GDP growth in the region of 3% to keep profits growth under pressure. Japanese stocks have fallen further and it is possible that they have now reached a trough, but the economic situation for such a cyclical market is not attractive. Asian markets remain cheap but are now subject to the uncertain impact of the Sars situation.
With the UK market having gained over 15% since the market bottomed in mid-March, our policy has been to take profits and reduce the overweight back to neutral. Other equity markets are also being retained at neutral, with the proceeds being held in cash. Insight will continue to underweight bonds, believing them overvalued with yields expected to rise. Cash holdings will be increased with the proceeds from UK equities, as other markets do not warrant increased investment at this time. We continue to prefer property and retain the overweight exposure.
Philip Barleggs is head of asset allocation at Insight Investment
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