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Finding new ground for equity markets

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The first half of 2011 saw the revolts in various Northern African countries, a devastating earthquake and tsunami in Japan and sovereign debt worries in peripheral Europe. In spite of these unsettling news events, equity markets still present attractive value going forward.

Late 2010, Frédéric Buzaré (pictured), Global Head of Fundamental Equity Management at Dexia Asset Management, argued: “We reckon that 2010 will prove to have been a transitional year and that 2011 should see a more balanced market environment. Sector correlations, which are at historical highs, should come down and stock-picking will come to the forefront again. We also believe that the predilection of investors for growth stocks, which have significantly outperformed the value style, will persist but become more selective.

Those views have turned out to be quite prescient. Sector correlations have come down indeed, and investors’ infatuation with growth stocks has lost some vigour. “The trade-off is now between cyclical and defensive stocks”, Frédéric Buzaré argues. “Our prudence towards emerging markets has also been justified, as these markets have been under pressure as a result of interest rate hikes, higher inflation and the end of QE2.”

Frédéric Buzaré argues: “It is not impossible that we are seeing a replay of 2008, namely a cocktail of higher inflation, an economic slowdown and rising commodity prices. But so far the central case remains that we find ourselves in the midst of a mid-cycle slowdown, which results in temporarily slower growth, without a break of the longer-term uptrend. Therefore, equities remain very attractive going forward. Real risk-free yields are negative, corporate profitability is very high, balance sheets are flush with cash and risk premiums have risen again of late. We believe that the return on equities will come primarily from a contraction of elevated risk premium. Trading at 10 to 11 times forward earnings, European equity have already discounted a form of soft patch. In a certain sense, it is hard to find compelling alternatives for equity investments right now.”

Of course, there are also risks. The first one is the end of QE2, the second round of quantitative easing by the Federal Reserve, by the end of June. Even if it is well flagged it may break the risk appetite and unleash some adverse feedback loops. Secondly, inflation may rear its ugly head again, although we do not believe in a sustained high inflation. Thirdly, if the 2008 scenario repeats itself, higher commodity prices may result in demand destruction, which will lead to a sharp slowdown in economic growth.

A new market paradigm is shaping the investment environment. The divergence between the developed and the developing world is widening by the day. We should be leery of new bubbles that may form as a result of unorthodox monetary policy. Asia has a great future ahead of itself but this theme is now overbought in the short term. Moreover, while Europe is struggling, European companies have never been stronger and the ones with a global foothold continue to thrive. The megatrends that we have laid out for some time now have not changed, namely the re-balancing of economic growth to the East, scarcity of natural resources and the imbalance between offer and demand of workforce in European countries.

In this environment Dexia favours the following investment themes:

Emerging markets: they have emerged much stronger from the crisis and should continue to thrive. However, in the short term we advise to adopt a more prudent stance: much will depend on US monetary policy.

Natural resources stocks: global demand for crude oil should reach record levels in 2011, still largely driven by Chinese demand. Emerging markets will continue to look for ways to secure energy supply.

Growth stocks: these have had a significant re-rating as a low-growth environment and in the other stocks, the lack of earning visibility has made investors favour them. We believe quality growth stocks or GARP (Growth At a Reasonable Price) will remain the place to be going forward. During the lost decade in Japan in the 1990s and during the Great Depression of the 1930s these stocks did quite well. We believe GARP stocks will continue to perform well in 2011 as they still offer the best risk-return profile. Sustainable and visible growth remains scarce and will therefore merit a premium.

Frédéric Buzaré concludes: “The first half of 2011 has been quite volatile. Equity markets now need some time to digest all this and find some solid ground again. Fundamentally, valuations and corporate profitability remain the key drivers for equities. Looking at these parameters, we maintain our positive stance going forward, knowing that it will probably not be a smooth ride.”

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