Disappointing mid quarter updates have brought investors back to reality

The upcoming week offers enough room for disappointment as crucial US macro data (ISM and employment report) and earnings reports of a few European big-caps (TotalFinaElf, Sanofi-Synthelabo, LVMH, L'Oreal, Arcelor) are on the agenda.

US Markets

Sentiment toward the global aerospace sector continues to be positive due primarily to significant buying in the U.S. It appears that money flows from the US are driving the overall flows into the sector. While the strength of money flows going into civil and defence segments is approximately the same, defence is currently more attractive as the stocks in that group are experiencing a higher level of money flow momentum. This should not come as a surprise considering that the correlation between the Aerospace & Defence sector with the S&P index is close to zero. Inflows should remain significant as long as U.S. economy does not clearly recover and other sectors remain volatile.

Boeing Co. (BA, $37.07, CSFB recommendation: Buy): we believe a strike by Boeing's machinist union is becoming increasingly likely based on news flow over the last few days. Rhetoric coming out of Boeing's largest labour union, International Association of Machinists & Aerospace Workers (IAM), suggests to us the company is taking a hard line on these negotiations and unwilling to compromise on the issue of job security, among others. As we said last week, it is difficult to predict the reaction of the stock price to a strike, but we think it is more important for Boeing to maintain its ability to cut costs over the long-term in what is likely to become a less labour-intensive business over time. Hold

Principal Financial Group, Inc. (PFG, $29.33, CSFB recommendation: Hold) announced that it is selling BT Financial Group to Westpac for AUD 900 million (approximately USD 500 million), with a potential additional payment of AUD 150 million (USD 80 million) contingent upon Westpac's ability to grow the retail fund management operation. The total after-tax proceeds to PFG should be approximately USD 750 million (excluding the contingent payment), which includes the consideration from Westpac plus a tax recapture and a gain on unwinding a hedge established when BT Financial was acquired by PFG in 1999. The lack of progress at BT suggests that management has correctly decided to exit the Australian market. We remain positive on the company for the long-term due to its good fundamentals and the quality fee-based recurring income. Hold

Citigroup Inc. (C, $32.75, CSFB recommendation: Strong buy) announced last Friday that it agreed to sell its New York headquarter for USD 1.06 billion, expecting to recognise a pre-tax gain of USD 830 million (approximately $0.16 a share). While the transaction should not affect 3Q'02 operating earnings, it should provide a cushion to fully diluted earnings in what has been a difficult quarter for the company/s capital markets businesses, as equity and M&A remain lacklustre and fixed income has weakened. We remain cautious for the short-term. In light of several legal issues in which the company is embroiled in, it is possible that instead of bringing the gain to the bottom line, it could be used to establish a reserve for legal costs. Hold

As the last quarter earnings have just ended, investors were looking for the recovery to be on the way. But with Intel (INTC: $16.67; CSFB: Buy), Nortel Networks (NT: $1.05: CSFB: Buy), Novellus Systems (NVLS: $24.46; CSFB: Hold) and Sun Microsystems (SUNW: $3.69; CSFB: Hold) guiding estimates down, they just confirmed what became more and more evident with key fundamental data declining. Intel's CEO said that he was not sure if the holiday season will boost PC sales and that the company would give a revised earnings forecast on the 5th of September. But it is not only the PC sales being weak, the server business is struggling equally, as corporate IT spending is cut or downscaled. Sun Microsystems guided its sales to be at the lower end of the range forecasted during its earnings report, but this range already included a 10-15% sequential decline in sales. Server sales did not pick up in August and it really starts to look like corporate IT spending may even continue to worsen. Also, with the consumer confidence weakening, jobless claims increasing, consumers will think twice, before spending on IT products, as there is no new 'killer application' making a PC upgrade necessary.

Microsoft (MSFT: $49.08; CSFB: Strong Buy) meanwhile expects to boost the sales of its gaming console Xbox, by lowering the sales price in Europe. This was a necessary step, as its competitor Sony lowered the price of its console Playstation 2. Microsoft has to keep up the pace with Sony in order to secure its market share. Sony has the advantage of a broader game portfolio and also has some very popular games to offer. Microsoft needs a broad installed base of consoles, as this is the key for the future software sales. The Xbox business is currently losing money, due to the aggressive pricing policy, but this will be made up by hefty margins on the game software, as soon as the software sales represent the major part of the Xbox related sales for Microsoft. The prices for the Xbox are very likely to come down in the US as well, just ahead of the Christmas season. But it will also depend on Sony's pricing policy and on the development of consumer confidence and spending for electronic goods.

We continue to recommend Microsoft as a buy, as we believe that the company's effort to diversify its business away from the PC will be successful and the stock is a relatively defensive bet on the technology sector.


European Equities

• Profit taking and negative corporate results caused European markets to drop. The Euro STOXX50 lost 3.96% for the week.

• Insurance and technology stocks remain the big drag on the overall market. Weak corporate results and outlooks caused these sectors to post heavy losses of 6.82% and 7.53%.

• The month of September could be a volatile. With the pre-announcement period starting, September 11 and the FOMC meeting coming up we expect to experience yet another volatile month.

• We reiterate our cautious stance on equities.

The German IFO business confidence index came in much weaker than expected. The figure of 88.80 was well below the consensus of 89.50. The latest decline to the lowest level in six months marks the third consecutive decline of this most important European leading indicator. The worse than expected result was due to the unprecedented floods in Germany. With an increasing chance of a double dip scenario, the weak reading on the IFO Index has also put a cloud on Mr. Schroeder's chances to be re-elected in the upcoming elections (Sept. 22). After a GDP growth rate of only 0.3% in the first half of the year the government's forecast of 0.75% growth for the year seems increasingly tough to be realised. This could prove to be the deciding factor in an election campaign that had little to offer in terms of different agendas between the two opponents.

Stora Enso (STERV FH; EUR 11.26) announced an asset write-down worth EUR 1.15bln in 2Q02 and the closure of some of its mills in North America. The company reassured the market that the profit enhancement plan was on track. While the impairment charge was not unexpected the market was surprised by the extent of the charge. However, with the uncertainty cleared we believe Stora Enso looks attractively valued and well positioned to benefit from a cyclical recovery in the paper market. We believe that demand and prices for the key paper grades are close to their trough. Furthermore the stock should be well supported by the share buy-back programme (only 35% filled so far) and the attractive dividend yield of 3.77%. We recommend buying the stock in the expected weakness ahead. Cyclical stocks need to be bought when the newsflow is the worst as it is generally too late to buy when the catalyst is visible. We view prices in the mid-teens as buying opportunities with a 12-month investment horizon. Stora Enso lost 6.17% for the week.

The newsflow out of the insurance sector remains negative as Swiss Re and Munich Re reported 1H02 results below expectations and Allianz (ALV GY; EUR 130.99) revealed its estimated claims for the flood damages in Central Europe. Allianz expects it might have to pay up to EUR 550 million in damages net of reinsurance payments, which would increase financial year losses by slightly below 2%. Allianz' estimates are much higher than the EUR 250 million that the market had expected. The stock lost 7.86% for the week.

Swiss Re (RUKN VX; CHF 106), which, among analysts, was the most preferred European insurance stock so far posted a massively lower 1H02 profit of CHF 118 million, down from CHF 1.35bln a year ago. Consensus was looking for a figure in the area of about CHF 1bln. Impairment charges amounted to CHF 917 million. The company cautioned that further impairment charges would be necessary if stock marks did not recover in 2H02. Swiss Re fell more than 13%.

Munich Re (MUV2 GY; EUR 185.69) posted a 2Q02 loss of EUR 383 million due to impairment charges of EUR 1.5bln. The company said it would no longer give a full-year guidance and estimates that claims resulting from the floods in Central Europe could amount up to EUR 1.1bln.

Oil stocks came under pressure after the strong performance over the past few weeks on reports that the OPEC might increase production at its next meeting on September 19, 2002. With oil prices around the critical level of USD 28 such an increase in production quotas seems increasingly likely based on several statements of OPEC officials over the past few weeks. Oil prices fell about 5% over the past two weeks while stocks like Eni (ENI IM; EUR 15.402) and TotalFinaElf (FP FP; EUR 145.40) are little changed. We expect some profit taking ahead of the upcoming OPEC meeting. TotalFinaElf is scheduled to report 2Q02 earnings on September 4, 2002. Two weeks ago the company reported a decline in 2Q02 sales of 6.8% on the back of lower oil and gas prices.

Today, Sanofi-Synthelabo (SAN FP; EUR 61.15) reported 1H02 figures, which were broadly in line with consensus. Sanofi-Synthelabo's net income rose 29% to EUR 828 million or EUR 1.13 per share. The company reiterated its earlier forecast of net profit growth for the full year in excess of 25% but expects sales growth to slow in the second half. This could bring the stock under pressure in the short term. A press conference is scheduled later today.

Nestle (NESN VX; CHF 322) declined 2.6% on the back of unconfirmed reports that the company might bid for Hershey Foods (HSY US; USD 75.75). The market is concerned about an eventual bidding war, should companies like Kraft Foods (KFT US; USD 39.77) or Cadbury Schweppes (CBRY LN; GBP 4.6775) join the race. However, Nestle's CEO calmed the market on Friday saying that a bid by Nestle without a partner would not be accepted by the US antitrust authorities. Nevertheless we feel that the risk of overpaying for an eventual deal due to its high strategic significance could put a cap on Nestle's near-term upside potential.

Based on recent comments regarding investment spending for technology from companies and analysts it is prudent to assume that there is no recovery in sight for the rest of the year. Should economic data remain weak the sentiment could even deteriorate from here. We continue to see further downside in the sector and would further reduce exposure to this industry.