Negative sentiments prevailed in Europe and the Euro STOXX50 closed the week 5% lower

US Markets

Since the beginning of the year, defence sector has outperformed the market. The S&P 500 Aerospace & Defense index lost 9.78% YTD while the S&P 500 lost 30.27%. We still believe the sector should outperform the index for the whole of 2002, especially stocks with significant exposure to the defence industry. We believe a likely war with Iraq and high defence expenditure should continue to support stock prices. However we would not recommend buying into the sector at current valuations. We would rather wait for further possible weakness before investing. Despite a weak commercial business, which limits upside room, defence companies' stocks trade at significantly high valuations.

General Dynamics (GD, $81.64, CSFB recommendation: Neutral) remains our favourite in this sector due to lower valuations than its competitors. Currently, GD's P/E ratio is at 17x while the sector trades at 20x. The company is one of the best-managed defence contractors, with a strong position in ships, combat vehicles and electronics/information systems. GD's defence business accounts for 61% of 2002 profits (source: SG Cowen). Despite weak demand for its business jets (Gulfstream), the stock price is expected to rise in 2003, thanks to improving defence profitability. Furthermore, we believe in a possible rebound in demand for its Gulfstream jets in late 2003-2004 period. For the short-term, we believe the stock price will remain under pressure due to weak civil aviation business and a $2.3 billion repayment to the U.S. Navy, together with Boeing Co. In 1991 when the A-12 fighter-bomber program was cancelled, both companies never paid back $1.3 billion received as progress payments and $1 billion in interest. They missed the payment deadline on September 30th, 2002. The Defense Finance and Accounting Service were told last Wednesday to take 'action as is appropriate'. So far, we do not know the kind of action the U.S. Navy will take against the companies. However, we believe that the measures will not be drastic enough to pose any significant threat.

Further to what was mentioned above, Boeing Co.'s (BA, $32.01, CSFB recommendation: Outperform) stock price should remain low and volatile. We believe current stock price is principally representative of BA's defence business. Despite BA's business mix shifting towards defence and aerospace and at the same time generating strong growth, the commercial aircraft business still represents 47% of 2002E BA's EBIT (source: Banc of America Securities). Tensions between Iraq, further airline bankruptcies, and a union negotiation representing the engineers in December would limit the short-term upside. We maintain our hold recommendation.

According to the research firm Thomson First Call 53% of the 1045 companies that provided a mid-quarter update for Q3 announced that they would miss analysts' estimates, 24% said that they would meet them and 23% would beat them. These downward revisions point to a reduction in the S&P 500 earnings growth forecast for the quarter to 7.1%, down from a 16.6% increase that was expected in August, according to a First Call poll.

The earnings revisions affected all the sectors and there is no real trend detectable as to which sectors would be spared the decline. Again this demonstrates how important stock picking is in the current market. The macroeconomic picture however impacts the IT sector quite hard and we do not see acceleration in spending on IT by corporations in the near term. The low earnings visibility and the uncertain economic outlook are very likely to contribute to further delays in the deployment of large IT projects.

After the sell-off over the past three sessions, a strong short-term rebound is not implausible as we could see some short covering. It is however risky as the fundamentals still point towards further downside, given the lack of economic growth and the political uncertainties related to the tensions with Iraq. Further, severe doubts remain over the durability of any rebound, as was the case with the short-lived one day rebound last week.

These tensions have had a positive impact on crude oil prices from the oil industry's perspective. With the West Texas Intermediate trading at around $30 a barrel, the prospects for the upstream players look promising, as these price levels provide strong support for investing into new upstream projects. In fact our recommended stocks Noble Corp (NE, $31.51, CSFB recommendation: Neutral), Schlumberger (SLB: $37.17, CSFB recommendation: Neutral) and Exxon Mobil (XOM: $33.06, CSFB recommendation: Neutral) have held up relatively well over the last three days' sell-off. We expect these stocks to continue to outperform (despite Schlumberger having issued a profit warning due to a loss in its seismic business), as we expect oil prices to remain at these lofty levels. Noble Corp is our favourite among the three, as it is a pure offshore drilling play and as such has a solid outlook.

European Equities


• The current broad-based slowdown in Europe was further confirmed when France and Germany reduced their GDP forecast for 4Q and next year respectively.


• CSFB increased overweight positions in pharmaceutical and banks at the expense of the cyclical sector. While we remain in favour of pharmaceuticals we are slightly more cautious on the banks in the short-term.

After excessive weakness on Monday, markets managed to recover part of it despite the fact that the ISM manufacturing index in the US showed a pretty strong decline. Sign of how weak European economies are was given by the France government, which reduced GDP forecasts for 4Q 02 and the German government, which lowered its forecast for next year to 1.5% from 2.5%. CSFB has already cut its 2002 forecast for Continental Europe by 50 bps from the beginning of the year and expects the euro area to grow by 0.7% from an initial forecast of 1.2% at the beginning of the year.

CSFB calculated that on an adjusted pre goodwill basis, consensus earnings growth forecast for 2002 for Europe fell from 11.3% in June to 3.7% (US from 14% to 9%). The bigger fall in Europe could mean that a poor short-term outlook for earnings is already priced into the market. Despite a short-term oversold situation we remain most concerned about the risk-reward scenario European markets currently show. Short-term earnings risk offset any chances that the oversold situation could result in a sustainable rally in our view. In the medium-term outlook we believe markets still have some further downside and we expect just another round of earning revisions for 4Q02. Therefore, short rallies are opportunities to reduce overweight positions in equities.

In CSFB's recent published 4Q02 equity strategy, the overweight positions in pharmaceuticals and banks were increased at the expense of the cyclical sectors.

Due to sluggish growth expectations in Europe with little signs of a short-term recovery, cyclical stocks are poised to underperform in the months ahead. Consequently, we reduce MAN (MAN GY; EUR 12.23) and Pechiney (PEC FP; EUR 26.28) to HOLD while we leave our BUY rating on Stora Enso (STERV FH; EUR 9.55), Arcelor (LOR FP; EUR 9.9) and Adecco (ADEN VX; EUR 40.5) unchanged.

CSFB argues that lower interest rates along the curve have historically been in favour of the pharmaceutical and financial sectors.

We reiterate the attractive valuations of Sanofi-Synthelabo (SAN FP; EUR 58.75) and Aventis (AVE FP; EUR 56.15). We would buy both stocks at EUR 55 for a trading rally to EUR 65.

The pharmaceutical sector was further affected by Schering-Plough's warning saying that earnings will be lower than market expectations. Concerns are based on future generic competition for its most important allergy treatment drug Claritin. As generic Claritin becomes available Aventis' (AVE FP; EUR 56.15) rival allergy remedy Allegra may loose sales. As a consequence, the share price saw some pressure during this week's trading.

Another area of concern for Schering-Plough is the ongoing patent litigation on Ribavirin. This may affect Roche's (ROG VX, CHF 98.30) launch of Pegasys, which was planned to be introduced in combination with a product using its own Ribavirin.

While we remain in favour of pharmaceuticals, we are slightly more cautious on the banks in the short-term. Banking stocks closed the week down almost 10% and were the worst performing sector of the week. Deutsche Bank was badly hit on the back of economic concerns and a downgrade by Goldman Sachs due to concerns about higher than expected provisions. The presidential election in Brazil causes further uncertainty to the sector. Investors fear that a victory for Lula could give his party a mandate for change at the expense of pragmatic economic management. Especially Spanish banks and other financial companies with investments and large loan exposure to Brazil such as ABN AMRO (AABA NA; EUR 11.47) are at risk if the country defaults. A second round of voting will just extend the uncertainty for another three weeks.

Vodafone (VOD LN; GBP 0.90) said that it expects subscriber growth to exceed 10% this year compared to an earlier guidance that was looking for an increase below 10%. On Thursday, the CEO Chris Gent said that the company was considering buying back shares if it failed to buy a 15% stake in French telecom company Cegetel. This is very good news as Vodafone in the past used its strong cash flow position to build up its global presence at high prices. The change in policy might indicate that the management is shifting to the value creation approach. Buying back shares would be an excellent way to show investors that the company cares about its shareholders. The stock rose 10% for the week.

France Telecom (FTE FP; EUR 8.71) announced Thierry Breton as its new CEO. Mr. Breton has an impressive track record. He is seen as the man behind the successful turnaround stories of Bull Computer (BUL FP; EUR 0.40) and Thomson Multimedia (TMM FP; EUR 15.40), which were both at the brink of bankruptcy when he took over. The nomination of Mr. Breton should increase the confidence in France Telecom despite the fact that the reduction of the EUR 70bln debt pile will be a very challenging task. France Telecom closed the week 10.40% higher at the very top of the European scorecard. A truly unusual picture!