Forget equities, go for bonds.

Author:Siddiqi, Moin

Although Western stock markets have so far resisted infection from the Asian 'flu,' they are bound to feel the effects of the fever come the summer. So where does that place the investor? Moin Siddiqi has the answers.

International fund managers this year face the formidable task of devising a vibrant portfolio strategy, one that will best be able to withstand the medium-term global implications of the Asian deflationary spiral. In an era of globalisation, any serious downturns in East Asia and Japan spill over into the key investment markets of the US and western Europe.

Picking the right asset allocation, namely a fine balance between equities, bonds and cash, depends on how professional investors see both short and medium-term market prospects, including the outlook for currency and interest rates. Major OECD markets could dip into a deflationary cycle, or at best, may experience low-inflationary growth. 1998 could be a rare year when fixed-income securities out-perform both equities and cash.

Despite extreme volatility in share dealings since late 1997, Western stock markets have so far survived the Asian storm. The main forces underpinning equities are low interest rates, share buybacks, and a tide of mergers and acquisitions sweeping across US and Europe. These markets may still suffer set-backs however by midsummer, as Asian-inspired profits downgrade. This will especially affect the manufacturing and commodity sectors which will hit the stocks of leading multinationals, which of course dominate major indices (companies such as the US Dow Jones or the UK FTSE-100).

The US economy is slowing, and this can only have an adverse impact on profit and dividend growth. Presently, shares have surged ahead of profits. Morgan Stanley expects earnings per share for the US Standard and Poor 500 companies to fall by 10% on average in 1998. Analysts project US earnings' growth of 5-7%, the lowest since 1992.

By most historical tests, Western stock markets are now looking overvalued, especially the US which is a major outlet for global funds. The P/E ratio on the broader Standard and Poor 500 index is 24, and dividend yields are only 1.6%. This extreme valuation could trigger severe correction on Wall Street in the second half, spurred by poor industrial corporate earnings. If Wall Street plunges, then every other major market follows suit.

My advice for risk-averse investors is...

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