Euro equities reduced but outlook is positive

May 19 2010 by Andrew Miller, The Journal

A FEW days ago, our Investment Committee - a wider group than the strategy team that writes this column - made an intra-quarter change to its recommended asset allocation stance.

Specifically, we reduced our overweight position in equities by 1.5 percentage points to 3.5%, cutting Continental European equities from overweight to underweight within the equity portion of our model portfolio (leaving the US and UK as the two remaining overweight positions in equity markets). We placed the notional funds into cash.

So, why did we decide not to “buy the dip”? After all, we’d been advising in previous columns that investors might want to take advantage of weakness to add to equity positions, not reduce them.

The answer is that we thought that the trauma in European bond and equity markets – together with the fiscal tightening that should ensue – would damage risk appetite and raise the danger of an economic setback in Europe at least.

Meanwhile, the apparent return of distressed trading conditions in the US stock market also seemed likely to dent investor confidence significantly, even if – as seems likely – it was simply an “air pocket”. At a more general level, the setback in global stocks was more brutal than we’d expected to see, and we felt that investors likely had time to wait for the fog to clear before resuming their long diversification out of cash.

Events subsequently have suggested that we have reduced the risk in our portfolio far enough. European politicians and central bankers have finally registered the need both for immediate financial assistance and for meaningful fiscal retrenchment in the fringe economies (outside the euro area, the new UK government also seems to be saying the right things about deficit reduction – we expect a formal package in late June, and still believe that a downgrade of UK government debt will be avoided). The financial measures being put in place in the Eurozone are doubtless imperfect, but in scale they are equivalent to a Eurozone equivalent of the Troubled Asset Relief Program – an equally imperfect package, but one that nonetheless did the job in the US. Meanwhile, the ECB may not be printing money, but it appears to have put a solid bid beneath the most troubled bond markets for the time being at least.

The fact that the euro remains fragile needn’t signal that the rescue will fail – rather, it could almost be viewed as part of the rescue itself. A further fall in the euro (our currency economist expects to see $1.20 in the months ahead) would be a safety valve that helps the Eurozone to export some of its deflation risk, and which might if anything boost the long-term credibility of the single currency project. The euro is hardly at or close to “crisis” levels – its real value is still pretty close to our economists’ estimates of “fair value”. In any case, some readers with long memories will recall seeing the euro being more than a third lower against the dollar a decade or so back.

So we remain positive on risk assets, albeit less so than we were, and see even the European equity market drifting higher from here – but now by less than our favoured stock markets.

Andrew Miller is regional office head of Barclays Wealth in the North East