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ECONOMIC
& MARKET COMMENTARY
February
2004
At our first set of
strategy meetings for 2004 our general views on the
economic outlook, asset allocation and portfolio
strategy have not changed. We expect a healthy economic
recovery, outperformance by equity markets, and our key
strategy favours cyclical stocks. Indeed, if anything,
events of the last month have strengthened our views.
Recent economic reports have been encouraging. This is
particularly the case for the major manufacturing
surveys around the world which are pointing to a strong
rebound. This is consistent with our view that the next
stage of the global recovery will be driven by capital
expenditure. Companies have deferred investment for
several years now while they repaired their balance
sheets. Cash flow is now strong, expenditure is needed
and in the US, the president has introduced enhanced
capital allowances for 2004 alone to help boost the
economy. This month we raised our GDP forecast for the
euro area from 2.0% to 2.25%. We also discussed growth
in the UK and Japan and although we made no changes to
our numbers we decided that the risks to our figures
were skewed more towards the upside than the downside.
Within our funds, our strategy is to retain a
pro-cyclical bias. This area of the market suffered
profit taking in December but has shown renewed
performance during January. History shows that cyclicals
do not perform for sustained periods of time and
therefore the question of when we should change tack is
crucial. We do not feel that this time is upon us yet.
We believe we can still look forward to material
upgrades to earnings forecasts for economically
sensitive stocks. Company managements have remained
fairly cautious in their comments on trading for fear of
raising expectations too high and brokers have been
reluctant to increase their forecasts without management
guidance. We also think the market is underestimating
the operational gearing of profit to top line recovery
after the extensive cost cutting of recent years. Our
expectation of modestly rising government bond yields is
also likely to favour cyclicals relative to other
sectors.
We remain overweight in equities in our managed
portfolios. The earlier comments on economic growth add
support to this view. At the same time, we see little
inflationary pressure and believe interest rates can
remain low, which will benefit the markets. Recent
corporate results have continued the trends of the third
quarter with figures, on balance, beating expectations.
In the US, for example, fourth quarter results to date
have seen 69% of companies report numbers ahead of
expectations, while less than 10% have been below. We
have raised our earnings numbers for this year for the
euro area, Japan and a number of Far Eastern markets.
Our raised forecasts leave equities in general looking
attractive.
Having retained the same overall stance again this
month, we took the opportunity to look at the greatest
risks to this position. The first was the risk of a
material rise in government bond yields. Our forecast is
for some upward movement in bond yields and we are
underweight in this asset class. While bond yields rise
it is likely that equities would struggle to make
progress due to the impact on the discount rate and the
impact on relative valuation levels between bonds and
equities. However, we feel bond yields could rise some
way before they made equities look relatively expensive
and when bond yields rose sharply last summer, equities
broadly took it in their stride. Additionally, the
reason for rising bond yields is likely to be faster
economic growth, which would have benefits for corporate
profits. If, on the other hand, the reason was rising
inflation or a buyers' strike of US bonds by their
trading partners in surplus, that would be less
favourable. However, we would generally expect rising
bond yields to see equities outperform bonds.
A second risk we looked at, which is not our central
view, is a revaluation of the renminbi. Our preferred
equity markets are the emerging markets, and China's
continued growth is a key part of that strategy. We
believe China will be reluctant to revalue its currency
materially given the need to provide employment for the
growing population migrating to the cities and the
vulnerability of the banking system. However, if it
happened it would slow exports, although not
substantially as the area would still be very
competitive. Inward investment would slow and this could
be beneficial in extending the cycle and reducing the
risks of over-heating. There could also be a negative
impact on global bonds as the prices of imported goods
from China would rise. Hong Kong could well benefit from
increased purchasing power by the Chinese consumer, as
the Hong Kong dollar would be likely to remain pegged to
the US dollar. Hong Kong is one of our favoured markets.
Having looked closely at the potential risks from rising
government bond yields and a revaluation of the renminbi
we feel the positioning of our funds remains correct.
Both would undoubtedly lead to short-term turbulence but
further out we do not think they would invalidate our
strategy.
Please
note: Issued by Threadneedle Asset Management
Limited, authorised and regulated by the Financial
Services Authority. Past performance is not necessarily
a guide to the future. The value of investments and the
income from them is not guaranteed and may fluctuate.
Changes in exchange rates may also cause the value of
investments to fall as well as rise. Anyone considering
dealing in the shares mentioned should consult a
stockbroker. The research or analysis included in the
report has been produced by Threadneedle for its own
investment management activities, may have been acted
upon prior to publication of this note and is made
available here incidentally. In some instances, the
information contained in this note, other than
statements of fact, was obtained from external sources
believed to be reliable but its accuracy or completeness
cannot be guaranteed. Any opinions expressed are as at
the date of issue but are subject to change without
notice. TAML are the investment managers for ZIL.
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2007