Crédit Lyonnais Asset Management is overweight in equities, slightly overweight in cash and underweight in bonds. We do not expect strong returns for this year. The stock markets should rise at a single digit pace compared with the current levels, and bond market returns should be either in line with cash or less.
Even if, from a fundamental point of view, we are rather confident about these predictions, we strongly favour diversification between the main assets classes in line with risk aversion. Indeed, in an economic recovery year, it seems wise to prefer equities and to avoid bonds. But specific risks remain. The terrorist attacks and the Enron story suggest that there is a case for new setbacks this year on the stock markets, apart from fundamentals which would tend to benefit government bonds.
We believe that the worst of the recession is over and that recovery is going to strengthen over the year, thanks to an improvement in US profit margins, which will push investment spending out of recession. The world economy will follow suit, but Japan will not fully benefit due to domestic problems.
However, we are not as confident as the consensus concerning the US and the European economic prospects for the second half of this year and 2003. Indeed, the consensus is that US growth will jump to a 3.5% trend by this summer and remain at this level. We tend to think that there was no real recession in the US because the private sector did not restructure its balance sheet. US consumers did not slash their durable goods spending at the bottom of the crisis. Thus, we fear that traditional ‘boosters’ will not play any role when activity improves : leverage seems capped. For the time being, we continue to gather data, but we do not rule out changing our stance in the coming months.
Equity valuations are neutral and the stock markets are expected to rise in line with profits. Profits will be boosted by the recovery but also by restructuring in the US, and to a lesser extent in the Euro-zone. US analysts have begun to revise their earnings forecasts upwards, and one could expect this will happen in Europe, thanks to a shorter lag with the US economy. Some factors could weight the markets, making the timing of the rebound more uncertain. First of all, it is difficult to estimate when the concerns about accounting practices will ease. Thus, for the short run, the risk premiums could stabilise or even increase to higher levels. However, the ‘Enron story’ is now at least partly discounted by the markets. Secondly, the fight against terrorism is not over.
We are overweight on the US, the Euro-zone and the emerging country stock markets. We are neutral on Japan: if this market is more risky due to deflation and problems with the financial system, it could also outperform with the world recovery and restructuring, thanks to attractive sectorial valuations.
We are overweight in cyclicals at the expense of the defensive sectors. More specifically, we are overweight in hard cyclicals, semi-conductors, business software and consumer cyclicals. We are neutral on financials but we prefer banks to insurance companies. We are underweight in utilities and pharmaceuticals.
The prospects of the bond market are more risky for the medium term. On the one hand, the inflationary risk is subdued but on the other hand, when the outlook becomes clearer, the Fed will have to normalise its monetary policy. If not, the risk of being ‘behind the curve’ could have negative impacts on the bond market. Moreover, President Bush is planning an encouraging fiscal policy for the coming years and is significantly weakening the budget balance prospects as far as there is a chance that the Congress supports the program.
In Europe, the risk that the German public deficit could break the 3 points of GDP ceiling and damage the European bond market. However, we tend to favour European assets versus US or Japanese assets.
Despite our recovery scenario, we remain cautious on corporate bonds. Indeed, in Europe, some specific risks in the telecom sector could drag down the market. In the US, there are some signs that a credit crunch may be possible. However, we remain overweight in emerging bonds despite the recent rally. This market will benefit from economic recovery, the rather encouraging Fed policy and the low level of issuance expected this year.
We expect a weaker Yen against the main currencies due to the expected injections of liquidity by the BOJ. We think that the US dollar should rise versus the euro.
Benjamin Melman is head of investment strategy at Crédit Lyonnais Asset Management in Paris

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