The first months of 2005 have continued the themes of the year before. We have consistently favoure...
The first months of 2005 have continued the themes of the year before. We have consistently favoured Asian and European equities over the US, and continue to invest in defensive equities with an attractive level of dividend yield and some growth potential.
We are relatively cautious on the performance of stocks at the aggregate (market) level, but continue to find good investment opportunities at the stock level. Consequently we believe that the environment will favour a stockpicking approach, and a global universe for searching out attractive investment opportunities. A low-return environment should emphasise alpha generation from good stock selection as opposed to a market directional beta strategy.
But what is exciting about the market now? The US Federal Reserve is bringing to an end the monetary stimulus that, coupled with the weak US dollar, has impacted the whole world. The end of the US dollar-carry trade (being able to borrow cheap US dollars and invest them elsewhere for higher returns) will now reveal whether the US economy has reached a level of recovery that is self-sustaining, or if the last two years of growth have been artificially created. Further afield, the impact of cheap US money has driven many asset classes to inflated values. Whether it is commodities, gold, bonds or real estate the game is now over, and fundamentals will now have to justify the valuations.
The answers we expect are that the level of indebtedness in the US, both at the consumer and government level, will magnify the impact of rising interest rates. Data shows that the slowdown has already begun, and we believe that the second half of 2005 will show the US slowing meaningfully.
The removal of the US dollar-carry trade will puncture short-term bubbles, and volatility will return to markets. Inflation will not become a concern (despite the continuation of a high oil price), as slowing growth and Asia's deflationary influence will keep price inflation low. The pressures on the cost bases of Western companies will ensure that the theme of outsourcing to Asia remains in place, which, combined with a stronger consumer position and strong currencies, places the region in the best position for investment.
This clearly supports the defensive bias in our portfolio, with Asia preferred to the US. Furthermore, Asian equities also offer yields that top those found in the mature Western markets, and this willingness of Asian companies to return their strong cashflows to investors makes these equities attractive on many levels. Even more promising are signs that Japan may too embrace efficient balance sheets and return surplus cash to shareholders. There is a vigorous amount of micro-level reform taking place, as Japanese companies are de-leveraging significantly, and are moving from very low dividend payout ratios with fixed amounts being paid out, to a more progressive approach. The ability of Japanese companies to generate attractive total returns through distributions is within their grasp.
We continue to favour more defensive sectors such as telecoms, tobacco and pharmaceuticals, as well as structural growth sectors such as other financials and oil. With a slowing backdrop and no inflation, those stocks where total returns are strong will prosper. This can come from strong cashflows returned to shareholders and/or growth delivered at a time of a general slowdown. Not surprisingly, we have very little exposure to the consumer, and are underweight retailers, leisure and automobiles, while also reducing the positions in inflated areas such as mining.
Within the financials area, we maintain our orientation to consumers with a low level of leverage and economies with a low level of consumer finance penetration. Specifically banks with such exposure are benefiting from the multi-year secular development of a country's financial industry and can avoid the concerning levels of over-leverage in some Western economies. Technology shares at this time remain too expensive, and we continue to run a large underweight position in this area.
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