The global economic backdrop is currently about as encouraging as it can be. Strong growth isn't simply restricted to a few hot emerging markets: the US is growing at around 3% a year, Japan is expanding at the most rapid pace seen in a generation and even Old' Europe could lose its reputation as an economic weakling.
Companies too are back on the front foot as witnessed by the sheer volume of mergers and acquisitions. After a few slow years, mergers and acquisitions activity started picking up in 2004 and this year it should reach levels not witnessed since the peak of the last boom. And to top it all, by historical standards interest rates and inflation are low.
Yet despite all this good news, there are also less encouraging developments to be taken into account. It is doubtful, for instance, that the blistering pace of economic growth can continue and we have definitely passed the sweetest stage of the corporate profits cycle.
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Indeed, firms increasingly have to take on more risk in order to keep profits rising and are doing so most obviously by making acquisitions. At the same time, they are increasing their borrowing, which is worrying after all, history tells us that the big deal often turns out to be a bad deal, particularly when it's funded with debt.
Nevertheless, there are bargains to be had in the current climate although we suspect that to make the most money over the next two years, we will need to be slightly more contrarian, investing in areas that haven't performed so well recently.
First, we like financial companies, such as banks, insurance companies and asset gatherers. The optimism among firms is good news for the banks that provide them with capital and advice. Healthy financial markets also mean retail financial services firms can boost sales of high-margin, equity-based products.
In terms of gaining exposure, we think the Jupiter Financial Opportunities fund is an excellent way to play this theme. Short-term timing is also good, as banks' share prices often go through a dull patch after their results are released in February and March.
We also see attractions in continental European funds and particularly like the UBS European Equity fund. It's run by a strong team and the portfolio takes into account some of the new performance trends developing in European markets.
On a more contrarian note, we would take a look at the US stockmarket. US growth has driven the global economy for the last few years, but it hasn't yet driven up US stock prices, despite valuations that are close to 15-year lows. Paradoxically, that could change if it becomes clear that growth is slowing, thereby allowing the US central bank to stop raising interest rates. In terms of funds, we think the Legg Mason US Smaller Companies fund offers a safe way to gain exposure. The fund's managers, Royce & Associates, are very conservative, and pay a lot of attention to downside risk.
What would we avoid? Commodities have been very hot and might continue to be so in the short term, given the amount of money that is discovering this new source of diversification'. But one day the pace of economic growth will slow and then prices will fall, possibly dramatically. Until they do, only the fleet of foot should consider getting involved.
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