NEW YORK - The global economic cycle has peaked, according to chief investment strategists at Deutsche Bank, and a sideways equity market in the U.S. and Europe is driving the world's smarter money managers to pay greater attention to Asia, as well as "sideline investments" that leverage burgeoning merger and acquisition activity.

While returns have been little more than mediocre in the last 12 months or so, offered Klaus Martini, global chief investment officer, private clients, Deutsche Bank, there are reasons for optimism within the traditional equity markets.

"Usually at the peak of an economic cycle, people are negative, saying, It's over, we've seen the best, and now we're falling apart.' But that's not true," said Martini, whose two-year-old unit is tasked with determining the investment strategy for the firm's private clients, or those individual and institutional investors with more than $2 million in assets.

Three Years More

In fact, the veteran fund industry executive said, with relatively solid fundamentals in the U.S. and Europe, as well as continued strengthening in Asia, the currently robust economic cycle could be prolonged by as many as three years.

Perhaps the most surprising element of this economic cycle, he noted, is the resiliency investors have shown in the face of repeated interest hikes by the Federal Reserve here in the U.S. and, most recently, terrorism abroad (see MME 7/11/05).

"Look what happened a few days ago in London," Martini said during a July 12 press briefing at the bank's midtown Manhattan headquarters, a week after terrorists struck London commuters.

"I was trapped in a Deutsche Bank building not far from the explosions, and reaction in the U.S. was that the Dow opened down 20 points and then recovered to close slightly on the plus side," Martini related. "That shows that we are living in a world today where there is a lot of money that has to look for investment opportunities, and it doesn't get scared away quickly."

Inflation, another factor that has been weighing on the minds of global money managers, is generally contained in the U.S. and Europe, added Benjamin Pace, chief investment officer, private wealth management, Deutsche Bank.

Inflation expectations are around 230 basis points, or 2.3% [in the U.S.], the private wealth CIO continued, expressing a similar outlook for Europe for the remainder of the year.

Pace, who oversees investment strategy and asset allocation for the firm's discretionary portfolio management team in the U.S., also believes that the Federal Reserve is nearly done tinkering with short-term interest rates, which should come as good news to fixed-income managers.

Stagflation Ahead

"We're close to the end of the tightening cycle. We're at 3.25% right now. We predict another 50 basis points of tightening before they stop," Pace said.

Unfortunately, Deutsche's strategists don't foresee an uptick in global bond yields in the coming months.

Among the factors contributing to the stagnation include: Asia's continued willingness to buy U.S. treasuries, one element of a current account deficit that has reached $195.1 billion, according to the latest figures form the U.S. Bureau of Economic Analysis; increased demand for long-term bonds among insurance companies and pension funds, driven largely by an aging population in the U.S. and other developed nations; and a global market that has become ultra-competitive with the growing tide of services and products flooding out of newly opened, previously Communist countries.

"There is no reason for yields to move significantly upward. We think we are in a long-term, lower rate environment," Pace said, adding that the firm is also de-emphasizing corporate bonds in its bond portfolios, largely on credit downgrades for General Motors Corp. and Ford Motor Co.

The question on everyone's lips in the broader fund industry, however, is what the next three months might hold for the equity markets in the U.S. According to Deutsche's strategists, the old saying, "sell in May and go away," doesn't apply this year. That's because, as presently strong 10-year Treasury bond prices weaken slightly and the S&P 500 flattens, the third quarter has become a buying environment in the equity markets.

35% Discount on Equities

In fact, using treasuries as a backdrop, Deutsche Bank estimates that equities are currently undervalued by as much as 35%.

"This is an opportunity to decrease your weighting in fixed income, which we've done in our portfolios," Pace said, citing as key drivers moderate inflationary pressures, robust corporate earnings, attractive valuation levels and a tendency for equity markets to rally by about 5% in the six months prior to and the six months after a final short-term interest rate hike by the Fed.

As such, Pace added, Deutsche Bank is standing by its prediction for equity markets to yield returns of 5% to 7% this year.

The window of opportunity, however, could be closing. Citing an index of leading economic indicators that has fallen in nine of the last 11 months and the cumulative effect of rising energy prices, Pace expects GDP growth to slow accordingly and equity prices to likely be impacted negatively as the markets exit 2006 and enter 2007.

"We're not going to make an official forecast, but we expect the slowing will continue [and] there will be some kind of impact from rising commodity prices, particularly higher oil prices, in slowing down the economy," Pace said. "I think the main difference in oil price spikes compared to 1974, 1979, 1990 and today is that this one is very much demand driven, as opposed to a supply shock." Thus, Pace went on to say, "higher energy prices are a function of strong global economic growth and so the impact probably won't be recessionary in nature."

But in the near term, those same oil prices, which are now ranging between $53 and $55 a barrel, are heavily influencing Deutsche Bank's portfolios. Martini said the firm will remain overweight in the energy sector as long as global demand remains high.

"There just isn't anymore oil to be found in the next five to 10 years," he said. "All the low-hanging fruit has been picked."

Rich Pharma R&D

The bank is also overweight in healthcare. The strategists think that major pharmaceutical companies have yet to perform to expectations and that merger and acquisition activity will soon rise as the larger players seek the research and development value within smaller companies. An aging population is further drawing the bank's interest in the sector. Value within surging niche areas like semiconductors also has the bank overweight in technology.

"We're always looking to the sidelines," Martini noted. "Investment in the traditional areas is over."

In other sectors, higher interest rates are decreasing Deutsche Bank's interest in utilities and intense price competition is creating an unattractive environment within the telecom sector.

Across the Atlantic, equities remain attractive, Martini said, as consumers outside Europe support a weaker consumption environment at home, merger and acquisition activity increases alongside the rising popularity of hedge funds, and, frankly, European equities remain cheap in absolute terms, as well as relative to the bond markets.

The global CIO dismissed investor concerns over the recent defeat of the European constitution, saying that it's largely a sentimental issue within the region.

In the Asia Pacific equity markets, the strategists favor Japan over China. The Japanese economy is finally shaking off a deflationary environment, and as employment expands and wages rise, they concurred, consumption should also increase. Solid economic growth in the U.S. and China - Japan's two major trading partners - is also promising. Japanese trade and construction companies, as well as banks, are on the firm's preferred list.

(c) 2005 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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