Strategists question returns on bonds as the outlook for stocks brightens The first half of the year was a bumpy ride for global equity investors, with uncertainty over the Iraq war, the Sars outbreak and weak economic conditions taking prices to lows in March and April. Since then, stocks have turned upwards, and further cuts in interest rates are raising questions about whether bonds will still deliver the kind of returns that have helped investors through the long bear market. The Dow Jones Industrial Average has risen 8.73 per cent and Hong Kong's Hang Seng Index has gained 3.38 per cent this year - a welcome respite after the weak performance of equities over the past three years. The biggest stock market gains in Asia have been in the Philippines, which has soared 24.14 per cent this year, and Indonesia, which is up 18.62 per cent. Among the optimists for the stock markets are JP Morgan's Asian strategist Adrian Mowat, who declared in a recent report: 'I remain bullish.' His approach for moving further into equities is to look for stocks with a history of good dividend payments and not to take a national or sectoral path. 'As someone born in Aberdeen, Scotland, a notoriously thrifty place, I like to call the style Gasp (Growth At a Scottish Price), with that right price being a reasonable dividend yield and a 'show me the money' track record of consistently rising cash dividends,' Mr Mowat said. Fund managers were expected to take more risk by buying more equities and moving away from safer assets such as government bonds, he said. As this happened, investors would initially be attached to high-yield stocks with a history of paying good dividends. Bonds may soon be in for a fall, according to Mr Mowat. Interest rates around the world have been slashed by central banks to low levels in a bid to stave off deflation. Low interest rates put upward pressure on bond prices. But if the central banks succeed in preventing deflation, short-term interest rates could begin to rise again which, combined with investors' desire to take on more risk, could cause bond prices to fall. However, it may not all be plain sailing for the stock markets. Weak second-quarter earnings announcements and poor economic data may cause stock markets to fall a little but not enough to trade on, according to Mr Mowat. At Citigroup Smith Barney, the Asian strategy team led by Ajay Kapur is also bullish on equities but takes a different approach. Regional equity valuations are low and historically have risen when Citigroup's own global economic growth indicator shows an upturn. Such a turning point in the growth indicator has just occurred. Citigroup recommends an Asian portfolio overweight on Taiwan, Singapore and Hong Kong but underweight on China. However, it expects all markets in the region to do well. 'Our strong convictions, however, are not along country lines - we think they all should do rather well this year - but along sectors,' says a Citigroup report. 'That is where our big calls are: pro-technology, exporters, underweight the domestics and base materials.' Citigroup believes consumer spending in the United States will remain steady. Strong growth is expected in US technology spending. However, ING Financial Markets believes Asian stock markets will weaken in the next few months before rallying next year. 'Historically, a good May-June has led to markets falling by over 10 per cent during July-September,' wrote ING strategists Markus Rosgen and Julian Leung. 'We expect Asian markets to give back between one third and one half of the returns since their March lows.' Investors should use the next few months to reorganise their portfolios during the market consolidation and prepare for gains in 2004, according to ING. Next year the weak greenback should benefit Asian stocks as the value of global trade rises in US dollar terms. In sharp contrast to Citigroup, ING has just cut its technology weighting to neutral and as a result lowered Taiwan to underweight. 'Technology has had a good run in the region and Taiwan has the largest weighting in technology,' according to ING. 'The outlook remains opaque [and] with utilisation in the global technology sector still low, pricing power remains illusive.' ING also believes that domestic stocks will gain from the weak US dollar, particularly the financial sector. The upward pressure on regional currencies increases the chances of Asian interest rates being cut and firms have the lowest leverage in 23 years - both factors should encourage borrowing and boost the financial sector. UBS' global asset management arm is moving towards equities with global stock markets now at levels 'pretty close to fair valuation', according to chief investment officer Jeffrey Diermeier. 'If you look at our overall strategies in bold strokes, we would be tilted away from fixed-income securities and towards equities,' he said. 'In equities, we are overweight the UK, overweight other parts of Europe, but not Germany. We are neutrally weighted to the Japanese stock market.' 'Relative to the other markets we are underweight the US but in a broad portfolio context, given the fixed income underweight, we are neutrally weighted to the US.' Like JP Morgan's Asian strategist Mr Mowat, UBS looks for high dividend yield stocks. 'Stocks that have the potential to pay a high dividend we would be overweight. We think the potential is the important thing,' said Mr Diermeier, who cited software giant Microsoft as an example. On fixed income, UBS has taken on riskier non-investment grade bonds where the returns are greater but so is the risk of not being repaid. However, some analysts are more cautious on the outlook for global equities. 'Equity markets rallied strongly during June but now appear to be pausing for breath,' Henderson Global Investors strategy analyst Kate Pybus wrote in a recent report. Company earnings are expected to peak this summer, which will prevent share prices from rising much further.