Tentative steps into equity danger zone

Despite ongoing concerns about the stock market, there are returns on the horizon, writes Simon Hildrey This would appear to be the worst of times for equities and equity investors. But after 40 per cent falls in western stock markets over the past two and a half years, it could be the best of times for private investors to start increasing their exposure to equities. Swiss private bank Pictet & Cie certainly thinks investors should now start taking tentative steps towards increasing their exposure to stock markets. At the end of October, Pictet rebalanced its model portfolios, increasing equity exposure from 30 per cent to 40 per cent. Pierre-Yves Bacchetta, head of investment strategy at the bank, says even though there are reasons to be cautious about investing in equities, valuations have fallen to such low levels that now is a good time to start raising clients’ exposure. Although Pictet’s portfolios vary according to the risk profile of each client, Bacchetta says on average, 50 per cent of equities are invested in Europe, including the UK. Of the rest, around 30 per cent are in the US, 10 per cent in Japan and 10 per cent in Asia. “We are still cautious about increasing clients’ exposure to the US because it is not easy to understand some companies’ accounts,” says Mr Bacchetta. “Companies also face an unknown level of funding to fill gaps in their corporate pension schemes over the next few years.” Optimistic prospects Despite growing concerns that Europe’s biggest economy, Germany, might follow Japan into deflation and possibly recession, Mr Bacchetta is optimistic about prospects for the continent’s stock markets. Over the longer term, Pictet is also bullish about prospects in Southeast Asia because of its favourable demographics and consumer demand. Dutch bank ABN Amro, however, is more cautious about a recovery in equity prices, although its model portfolios also have a 40 per cent exposure to this asset class. Gerben Jorritsma, head of discretionary portfolio management at ABN Amro, says rather than advising clients to increase their exposure to equities in developed markets, it is recommending that they consider investments with equity characteristics, particularly hedge funds. “We are cautious about raising our clients’ weightings in equities because stock markets are likely to produce a couple of further nasty surprises over the next few months,” explains Mr Jorritsma. There is still a danger of a double dip recession in the US at the end of this year or in the first three months of 2003, he argues. This would be followed by only a slow recovery in the economy and stock markets. ABN Amro does not believe there will be a strong stock market recovery next year because of ongoing structural imbalances in the global economy. “The world economy is still suffering from over-capacity,” says Mr Jorritsma.” “The lesson clients have to learn from the past three years is that they should not expect the high returns they enjoyed in the mid to late 1990s. Equity returns are likely to produce an average 7 per cent to 10 per cent return a year in the future.” Enhancing returns According to Mr Jorritsma, clients there- fore need to diversify their portfolios over different asset classes to enhance returns and moderate volatility. ABN Amro’s model portfolio has a 5 per cent exposure to hedge funds and 2 to 3 per cent allocated to emerging markets. DWS, the private client arm of German bank Deutsche, is also cautious about increasing exposure to equities even though it believes that stock markets will end 2003 at higher levels than 2002. It argues that private investors should currently split their portfolios three ways – one-third in money market funds, one-third in bonds and one-third in equities, with a slight increase in exposure to stock markets over the next couple of months. According to DWS, there is still a risk of short-term falls in the value of equities, particularly if there is a conflict in Iraq over the next few months. DWS advises clients to invest in oil stocks as a hedge against a general fall in equities in the event of a war. It does not believe economies will enjoy strong growth in 2003. DWS estimates, for example, that growth in European economies will be between 1.2 per cent and 1.5 per cent next year. For clients returning to equities, DWS favours the US above Japan and Europe. But DWS warns clients that the US is still a stock-picking market and the recovery is likely to be slow next year even though equities have been oversold. Diversification is also the mantra of Coutts Bank when advising its European clients through its branches in Zurich, Geneva and Monaco. “The starting point at the moment when advising private clients is the need for diversification by using hedge funds and bonds because stock markets continue to be volatile,” says Gayle Schumacher, head of research at Coutts. “At current levels, equities offer high potential returns but they also carry high risks in the short term.” “Over a two to three year investment period, however, we expect clients to gain much better value and higher returns from equities than the bond markets.” Greater confidence Schumacher believes that stock markets will continue to be volatile in the first six months of 2003 but by the second half of next year there should be greater confidence in global growth. Given this view, Schumacher says private investors should only start increasing their exposure to equities if they are “prepared to ride out the short-term volatility”. Within equities, Coutts favours the Pacific Basin region because it is winning market share around the world from companies in Europe and Latin America, equities have attractive valuations and there is strong consumer demand within the region. Ms Schumacher is far less optimistic about continental Europe because three policy levers that can be used to boost the economies – interest rates, government spending and currency devaluations – “appear to be jammed at the moment”. Private client advisers across continental Europe believe it is unlikely that equity prices will fall much further after their 40 per cent descent over the past two and a half years. They all agree, however, that the recovery will be slow and not without volatility. Current stock market valuations offer private investors attractive potential returns but only over a two to three-year time period.

Small but sustainable growth Private client advisers may be cautious about stock market recovery next year, particularly in Europe, but Threadneedle Investments is optimistic Germany will avoid deflation and recession. According to Consensus Research International, Threadneedle is the fourth most popular asset manager with intermediaries in Germany. Its survey this summer revealed that 39 per cent of intermediaries said Threadneedle was among the five asset managers they invested in most often. William Davies, head of European equities at Threadneedle, argues that Germany will be able to sustain positive growth, albeit at a low rate over the next year, and prevent deflation because the government will breach the 3 per cent cap on borrowing under the euro-zone’s Stability and Growth Pact. The German economy, as well as other countries such as France and Italy, will be aided by a cut in interest rates on December 5 by the European Central Bank, according to Mr Davies. While he does not believe there will be strong economic growth in the euro-zone next year, Mr Davies predicts it will reach 1.75 per cent. This would be an improvement on the estimates for 2002 of less than 1 per cent. With share prices at an average of about 15 times next year’s earnings, Mr Davies argues that valuations are “not particularly stretched” but he does not envisage a significant recovery in earnings in 2003. “If the threat of war in the Middle East is behind us by the middle of next year then stock markets should get stronger in the second half of 2003,” he adds. Such a gentle recovery should enable cyclical stocks to do well. But Mr Davies warns investors that not all cyclical sectors are undervalued at the moment. “The paper sector offers good value but chemical stocks are not cheap.”