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Equity Plays a Hard Find in Dead-Level Economy: Deutsche Bank Experts Point to Asia, Energy, Big Pharma for Opportunities

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.