Why overweight equities

Over the past few months, financial markets have been rather anxiety-prone and the analysis of todays’ key issues has comforted in decision to overweight equities

MARKET ANALYSIS

Our positioning is driven by our response to the following three major issues.

• The first issue concerns how soon the U.S. Federal Reserve will have sufficient confidence in the country’s economy to raise key interest rates to levels above zero.Considering that domestic economic growth is far from spectacular and that inflation is still far from its 2% target, the Fed will have to hint towards the normalisation of monetary policy rather than impose a strict tightening of monetary conditions. It seems clear to us that the low interest rate environment is set to last and that the Fed will only put an end to this ultra-expansionist territory very gradually. Nevertheless, the end will definitely occur within the next 6 months, thereby preventing the markets from speculating over a continued expansion of multiples on the U.S. stock markets.
• The second issue concerns the sharp turnaround on the Chinese equity market and how to evaluate the potential implications for the global economy. Concerns over the momentum of the Chinese economy have intensified over the past few weeks, verging on generating a negative market environment. In July, most commodity and emerging equity markets fell back while yield curves in developing countries flattened. While we understand these concerns, we also believe they are excessive. First, one should not worry too much over these ups and downs on a market that is striving to gain in maturity, but hasn’t got there yet. The Chinese government took a series of immediate measures designed to avoid a disorderly and lengthy adjustment and the outcome is reassuring. Second, the real estate market is showing signs of stabilisation, and in some cases, recovery, in large cities. The property market has a much stronger impact on the economy than the stock market. Third, one should remember that the slowdown in investment and on the real estate market was desirable for China and wished for by the government – and we believe the Chinese authorities would not hesitate to stimulate business if the downswing turned out to be too brutal. And fourth, the latest surveys published in Europe, and in particular July’s IFO survey, show that for the time being the slowdown in major emerging countries is not having a material impact on the business climate in Europe – unlike what we had observed a year ago.
• The third issue which has been a source of concern for the past months, is the ability of Greece and its creditors to reach an agreement that would allow the country to receive a first instalment of the new European loan before the major payments due in August (to the ECB) and September (to the IMF). It is undeniable that the agreement reached by Greece and its creditors carries high risks and could degenerate into a political crisis, triggering early elections that would block relations with creditors at a time when the country would have to meet repayment deadlines. Volatility could therefore return on this particular issue, even in the near-term.

OUR CONVICTIONS
ON EQUITY MARKETS:
In this environment, European and Japanese equities appear to offer the highest potential. These regions have only recently emerged from the crisis and corporate margins offer strong potential upside, while earnings growth could beat expectations. This could turn out to be a new growth driver for global equity markets, as in 2004-2006. In this respect, we believe the economic momentum will have a larger role to play than usual. And we continue to believe that economic growth in developed countries is due to accelerate. On the basis of our analysis, we therefore prefer to overweight equities over bonds, with a particular emphasis on Europe and Japan, where due to the lag in the cycle ultra-expansionist monetary policies will continue to buoy markets for longer. Concerning Chinese markets, although we will keep a close eye on the momentum of the Chinese economy, we do not wish to extrapolate on the market’s fears and adjust our positions.

ON BOND MARKETS:
Volatility could pick up again. During the previous month, in light of the Greek crisis, we had temporarily strengthened our exposure to “core” Eurozone sovereign debt and to the dollar.
We shall maintain this position, as well as our other asset allocation choices.

Benjamin Melman – Head of Asset Allocation and Sovereign Debt – edmond de rothschild asset management (france)