LONDON, 13 September 2004 — Global stock markets burst into life last year shortly after the invasion of Iraq had started. Many investors are therefore inclined to think of the recovery as starting at the end of the first quarter of 2003. In investment terms they are probably right. But in economic terms the recovery has been going considerably longer and is starting to look mature.
This is most obviously the case with the US. Remember that the US barely experienced a recession in 2000 and 2001 after almost 5 years of above-trend growth. GDP statistics get revised all the time but the latest figures show a continuing recovery since the third quarter of 2001. That was three years ago.
If past cycles are a guide to present one, the likelihood is that we are past the peak in terms of the overall growth rate and in terms of the improvement in corporate earnings. A peak of 5 percent, in terms of the 12 monthly GDP growth rate, was reached in the first quarter. This compares with peak rates of growth of 8 percent in some previous cycles and suggests that the present upswing will be relatively weak.
In Japan also, the cycle is no longer young. There, GDP has been growing for around two and a half years, as the upswing started at the beginning of 2002. However, as Japan has underperformed for more than a decade, there is a good chance that GDP growth in the present cycle will be a bit stronger then in recent ones.
The US makes up around half of global stock markets in terms of market capitalization. So our assumption that US profits growth has peaked implies something in the same direction so far as global profits growth is concerned. And this is the argument behind our continuing with a relatively low commitment to equities (25 percent) in our absolute return asset allocation.
While a low commitment to equities looks like a good call from the strategic point of view, there is reasonable chance that equities will enjoy a “trading rally” over the balance of this year.
First, US equities often do well in the second half of US presidential election years.
Second, many “experts” say oil prices are trading above what might be warranted on the basis of fundamentals. If oil prices have indeed peaked, markets should respond positively.
Third, investors are beginning to suspect that the rising trend in US interest rates may not have that much further to run. Between February and May, US employment grew strongly according to the nonfarm payroll data. Since then (i.e. From May until July) the data have been weak.
A further issue to consider on the interest rate front is fiscal policy. If an attempt is to be made to rein back the Federal Budget deficit, it will probably happen next year so that the pain may have passed somewhat by the time the November 2006 Congressional elections take place. Any meaningful tightening of fiscal policy would probably bring forth some compensating relaxation of monetary policy.
A 25 percent commitment to equities is complimented by a 25 percent commitment to alternative investments and a 40 percent allocation to bonds. The remainder (10 percent) is held in cash. Although our allocation to bonds is relatively large, most positions are in shorter-maturity issues. In some accounts, the alternative investment exposure includes a small commitment to real estate but the basic allocation is to low-risk fund type investments.
As for equities, the assumption that profits growth will slow from here argues in favor of non-cyclical sectors such as health care and consumer goods. Elsewhere, we retain an overweight position in energy, though we have reduced our exposure in recent months. In terms of regions, our favored area is Asia, both Japan and the “Tiger” economies on the Asian Pacific rim.
Our allocation in the alternative investments area is made up almost entirely of low-risk fund of hedge fund products. We look to such investments to provide some portfolio diversification and, over time, to yield returns that are better than cash.
With regards to fixed income, we continue to favor credit risk as opposed to duration risk. Bond exposure is focused on shorter-dated maturities. Indeed, last month we cut further our recommended duration in both USD and CHF bonds. Partly on the basis of currency strength we view sterling bonds as particularly attractive at the present time.
Finally, with US interest rates still likely to rise over the next six months, we view the dollar’s trend decline as having run its course. Elsewhere, we are most positive on the British pound and expect it to outperform all major currencies, especially if allowance is made for higher sterling interest rates. Ultimately, the Japanese recovery and Japan’s structural trade surplus both point to a stronger yen. (Habib F. Faris is vice president at Clariden Bank, London.)(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden bank makes no representation or warranty as to the accuracy, reliability, or completeness of the information.)
