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Waiting for the rally to take flight

Every investor wants to know when markets are going to rally. Until now, analysts have tended to fall back on the “It&#39ll be all right in the fourth quarter” response. But sentiment has, if anything, worsened in recent weeks.

The challenge for international portfolio managers is to make the most of the opportunities that do exist. While it has been a turbulent time to invest in technology and related stocks, there have been opportunities in other areas such as energy, financials and pharmaceuticals.

As we move towards the end of the year, we have a situation where market sentiment is being subdued by a number of factors. Investors are anxious to know if the US economy can achieve a soft landing and what effect the weak euro will have had on the corporate profitability of multinationals.

There have also been a series of disappointing earnings warnings from big name stocks such as Intel, MSDW, Eastman Kodak and Dell.

Market sentiment has been given a further knock by what appeared to be, for a while, an uncontrolled rise in the oil price to more than $37 a barrel at one point.

These warnings place heavy pressure on the market in the short term and this is not likely to change until we get some form of catalyst that will bring cash-rich investors back into equities. The market needs to see that the earnings picture is not as bad as recent announcements have suggested.

The catalyst could be central bank intervention in the currency market. It helped prop up the euro marginally and, combined with the stabilisation of the oil price, has helped to stem the tide. But the markets want more than that.

Notwithstanding possible valuation problems on the stockmarket, the US economy is in good shape as we run up to the presidential elections in November. We believe the US economy is slowing and that it will achieve a soft landing, retaining average growth rates of around 3.5 per cent.

Last year, we strongly bel-ieved we were about to see a reawakening in the Japanese market. Since then, our view has changed due to a significant turn-round in monetary policy. We now fear Japan is now going back to a situation of slowdown or recession.

Until this year, the Bank of Japan was lending reserves to the banks at zero cost. The banks then used these reserves to fund massive lending to the government. Japanese companies were receiving funds from the government, from the markets and from foreigners. As a result, corporate liquidity surged and companies could afford to pay back debt and to expand. For the first time, Japan was achieving debt reduction and economic growth.

When the Bank of Japan announced in the spring that it would be raising interest rates, it took away the incentive for banks to lend into the Japanese government bond market. So, money creation has almost stopped. As the banks stopped lending, so their demand for reserves fell and reserve money growth has therefore slumped. The last time that money growth slumped like this, the economy weakened and the yen soared. Both may happen again.

Having said this, there are grounds for optimism. While the liquidity squeeze in Japan and pressure on exports has negative implications for the rest of Asia, it is positive for the US because cheaper imports will dampen inflation and will add to the soft landing scenario.

So, while our current strategy is one of caution, there is the potential for a significant upside move. If US market liquidity continues to tighten, with investors reducing their exposure to equities in favour of cash, the Federal Reserve will at first attempt to talk the market up but, ultimately, it will trim rates down.

The thing to emphasise is that if the earnings situation improves and with sentiment at such a low, there will be a powerful rally in the markets.

Latest information suggests a third of total mutual fund assets of over $6trn is currently held in cash funds. So, the market is sitting tight waiting for the catalyst.

If we do not get any more high profile earnings surprises, that may trigger the pick-up in sentiment. But if a hard landing trend should emerge, expectations will have to be reassessed and the market trend could be significantly lower.

The stocks with a highest positive return in these conditions are financials and interest-rate-sensitive sectors – a bit of technology and, at the moment, energy. Oil prices do not need to reach $40 to make money because we believe analysts are still factoring in earnings at around $20 a barrel.

In the conditions that exist now, it has been sensible not to have any single country holdings or significant emerging growth bets. Instead, we have placed our faith in mid caps and, where possible, small caps whose valuations have been severely downgraded.

In Europe, we are taking a neutral stance as sectors we had previously backed, including telecoms, have hit problems with the cost of 3G lic-ences and uncertainty about the potential returns for 3G services, where there is no precedent. The large debt burden, we feel, is bound to affect their performance.

Although this scenario may not sound overly bullish, we must come back to the point that some sort of retracement was inevitable following the remarkable run-up we saw in late 1999 and early 2000, particularly in the Nasdaq and global TMT stocks.

So while this year has been challenging for investors, the rerating that has resulted for many stocks has created far more opportunities for growth going forward from here.

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