LONDON, 10 June — Since reaching its peak for the year in mid-March, the Morgan Stanley Capital International (MSCI) world index has lost roughly 4 percent of its value. In early May it was down as much as 7 percent. However, the economic data published in the last month have been very good on the whole.

Noteworthy data include US first-quarter gross domestic product (GDP), published at the end of April, which was up 5.8 percent. However, the lion’s share of GDP growth in the first quarter, 3.6 percent in fact, was due to sharply reduced inventory cutbacks. Even if we ignore the exceptional changes in inventories, US demand still rose 2.2 percent. Bearing in mind the GDP figures adjusted for inventory changes, demand is expected to pick up to around 3.5 percent to 4 percent by the end of the year.

Generally speaking, economic data in the USA and Europe remain positive. Many investors seem plagued by the fear that the nascent economic upturn will soon peter out. At first glance, some of the economic data published in the last month seem to underpin this view. For example, the US Purchasing Managers’ Index, which has risen sharply in recent months, weakened somewhat between March and April. This drop does not provide cause for concern, however, as the current index level of 53.9 signals economic growth of 4 percent. If this indicator of sentiment were to fall to 50 points, it would still imply economic growth of almost 3 percent.

The situation in Europe is quite similar. Germany, for example, saw a fall in the business climate index calculated by the Center of European Economic Research (ZEW). This dropped from 70.6 to 66.3 points in May.

Of the three major economic areas (US, Europe and Japan), the recession in Japan’s industrial sector was the most accentuated. Last December, Japan’s industrial production was down 15 percent year-on-year. By contrast, the annual growth rate of industrial production in the USA and Europe bottomed out at 5.9 percent and 4.2 percent respectively. This discrepancy is doubtless due to the fact that Japan had to cope with the most severe structural problems as well as the cyclical downturn.

Even if these structural problems have not (yet) been solved, we believe Japan is in a position to profit from a cyclical recovery. The fact that inventory adjustments are already far advanced supports this view. The ratio of inventories to sales is now so low that demand is having to be met through current production rather than inventories accumulated in the past. We therefore expect industrial production to pick up in the coming months. In the past, a low ratio of inventories to sales has always proved a reliable indicator of a recovery in industrial production.

The Japanese economy is boosted almost entirely by demand from abroad and the driving force behind the timid upturn in Japan is not domestic but foreign demand. While the order intake from the domestic market continued to fall, incoming orders form abroad rose in three of the last four months. Japan is benefiting from the economic upturn in the Pacific region, the destination for more than 40 percent of Japanese exports. Leading indicators in South Korea and Australia, for example, are clearly pointing upward. The exports of countries in the Pacific region are also growing at quite considerable rates.

Profit recovery is expected to reduce high valuations as price/earning ratios (PERs) suggest that the equity markets are not cheap at the present time. However, we do expect US corporate profits, which have the sharpest slump since 1980 behind them, to rise sharply over the coming quarters. This view is underpinned by phenomenal productivity growth of 8.6 percent in the first quarter, which pushed unit labor costs down by 5.6 percent. Due to the sharp fall in unit labor costs, we can expect profit growth to be between 25 percent and 30 percent in the coming quarters. Better profit figures will bring what are at present very high valuations down to a fair level.

Even in Japan, which had to cope with two difficult profit recessions during the 1990s, there are indications that the latest slump in profits has at least eased. This is due to lower growth in unit labor costs. In a similar scenario to that in the United States, Japanese earnings are drawing additional benefit from the global economic recovery.

In contrast, the bond markets remain vulnerable to imminent interest-rate hikes by the central banks. We therefore continue to overweight equities in relation to bonds. As long-dated bonds will suffer more than those at the short end when interest rates are raised, we favor short maturities and set the duration in the bond portfolios below the corresponding benchmarks.

Our equity strategy at sector level largely reflects our positive economic outlook, too. We remain overweight in the materials and industrials sectors, while we leave the defensive consumer staples sector underweighted. Although defensive, we leave the health care sector at overweight. Unlike the other defensive sectors, it has performed comparatively poorly in recent months. According to the relative PERs, health sector shares are currently favorable priced.

We take a more cautious stance toward the telecom services and information technology sectors. Within IT, we prefer the computer and semiconductor segments and avoid telecom equipment industry. While there has been evidence of increasing capacity utilization rates in the computer and semiconductor segment (in the United States) for some months now, capacity utilization at telecom equipment industry remains at its lowest level for years.

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(This article is contributed by Clariden Bank, London, which is a wholly-owned subsidiary of Credit Suisse, Zurich, specializing in asset and client relationship management.)