International | Oct 04 2006
By Chris Shaw
The correction in global equities during the September quarter has been all but forgotten in developed markets, which have bounced back to be trading at or near their highs of May. Emerging markets have found the going much tougher though, Lehman Brothers estimating they remain about 7% below their peaks of a few months ago.
In the broker’s view all signs point to a continuation of this underperformance relative to developed markets over the next 12 months, so its global strategists continues to recommend investors remain underweight emerging markets.
Lehman lists several reasons in support of this view, the first being a period of strong fund inflows into emerging markets, as has been the case recently, has historically been followed by a period of underperformance relative to more developed markets. Looking at this in more detail for the past year, the broker notes the funds flow has been consistent with forward 12-month performance in line with developed markets, which is not a strong enough return to justify going overweight emerging markets.
At the same time, corporate earnings growth in these markets is lacklustre relative to that being generated in developed markets, a trend also unlikely to reverse in the next year given the apparent loss of global economic momentum.
Despite this apparent earnings risk the broker notes valuations are not overly supportive, as even allowing for interest rate differentials the respective valuations are only consistent with emerging markets performing in-line with developed markets, which is not a good enough outcome when the additional risks of investing in such markets are factored in.
In terms of weightings in the various asset classes the broker’s view of likely poor relative performance from emerging markets has not impacted on its equities position, which remains overweight compared to benchmark. The broker suggests 70% of funds be invested in equities compared to the benchmark of 60%, with the remaining 30% in bonds, a slightly underweight position compared to benchmark of 35%. Cash is also underweight, the broker recommending no cash weighting compared to the benchmark of 5%.
Looking at various equity markets, the broker’s top picks are Japan and continental Europe, the former as the economic recovery should drive an extended profit cycle and yen strength will boost US dollar returns and the latter given the expectation corporate profits can continue to grow. The broker is also recommending a slight overweight position in Asia Ex-Japan, while it is underweight the US and emerging markets, including Latin America. Large capitalisation stocks are preferred, as the broker regards them as cheap relative to historical multiples.
In sector terms the broker is positive on growth stocks such as healthcare and technology, while it has moved underweight on cyclical stocks given relatively full valuations at current levels. The broker also suggests being underweight both consumer staples and utilities, as stocks in these sectors look expensive unless they can generate earnings growth above the levels currently being forecast.
