European equities have had a bad year and U.S equity markets are still under pressure

US Stocks
S&P 500 ended with a performance of -23.37% for the year 2002. For the coming months, several issues could still pressure the U.S. equity markets, namely a staggering U.S. economy, risk of a war on Iraq, and tensions between the U.S. and North Korea.

However we believe some sectors could benefit from these concerns and the Defence sector should be one of them. We believe if a war occurs, defence contractors should outperform the market. Furthermore, the Bush administration should continue to support this industry with high defence spending. Nevertheless, this positive stance should not hide some risks in the industry. Firstly, during the last month, the Pentagon announced a review of the major weapons programs, due to budget over run. Some companies could lose out at the expense of other defence contractors. Finally, the U.S. government has charged a Boeing Co. (BA, $33.88, CSFB: Outperform) unit and Hughes Electronics Corp. (GMH, $11.13, CSFB: Restricted) with illegally transferring space technology that may have helped China to develop rockets and intercontinental missiles. Even if this news has no impact in the short-term, it could generate further pressure for the long run. Amongst the defence contractors, Northrop Grumman Corp. (NOC, $99.80, CSFB: Restricted) and General Dynamics Corp. (GD, $80.90, CSFB: Outperform) are our top picks. The companies have strong fundamentals and a low correlation with the U.S. equity markets. Furthermore NOC has just completed its acquisition of TRW, and now covers a wide range of defence segments, from carrier building to satellite communication. We have a BUY rating on NOC, GD, and BA.

Diversified financials should remain under pressure in the short-term due to the concerns we mentioned above. Furthermore, the fourth quarter was the worst quarter ever for corporate debt ratings according to Moody's, which issued seven downgrades for every upgrade (source: Friedman Billings Ramsey & Co.) Coupled with two of the ten largest bankruptcies in history (Conseco and United Airlines), renewed concerns over corporate credit quality have emerged. However, if the U.S. economy shows clear signs of a recovery, meaning better credit quality and increasing capital market businesses, this sector should attract more investors in the second half of 2003. Key players are JP Morgan Chase & Co. (JPM, $25.44, CSFB: Outperform) and Citigroup Inc. (C, $36.35, CSFB: Outperform) due to their leading positions in both segments. Currently we do not follow JPM. According to the dividend discount model, C stock price is undervalued and its theoretical price should be around $42. However we maintain our HOLD rating on Citigroup for the short-term, believing the company to have a greater downside risk due to a lack of investor confidence.

Europe
• Europe's structural problems, tight fiscal policy and limited power of its monetary policy seem to make it dependent on a global recovery.
• A possible way to play such a market is through dividend paying stocks and defensive sectors such as pharmaceuticals and food producers.
• In the short-term, hope for a boost to growth lies with the ECB. We believe interest rates still have room to go down within the 1H 03.
• Cyclicals and banking stocks could benefit from lower interest rates.

European equities have had a bad year. The DJ Euro Stoxx 50 closed 2002 down 35.7%. The more defensive market such as Switzerland and the UK only relatively outperformed the others closing down 26% and 22% respectively. The worst market was as expected Germany (down 41%).

Looking at the sectors, food & beverages, energy and non-cyclical goods and services relatively outperformed the market, whereas insurance and technology closed the year more than 50% down.

But will the New Year bring any cheer? The first trading day of the New Year saw the market increase by 5.7% mainly based on strong US manufacturing growth in December. However, business and consumer spending remain weak and according to the ECB Euroland is expected to grow by only 1.1% in 2003. One could argue that compared to a year ago European equities are now more reasonably valued than at the start of 2002 (consensus forward PER of 13x vs. 18x a year ago and 16x as a 15-year average).

However, we would be more cautious and argue that structural deficiencies prevail and could represent potential for further setbacks. Germany - the continent's biggest economy - looks the most vulnerable. Business confidence fell for a seventh straight month in December, unemployment is climbing and the German consumer was spending around 16% less in Christmas 2002 compared to a year earlier. Creditreform - a German consultant firm - warned that the number of corporate failures would again rise sharply this year.

Fiscal policy will be mostly tight and, at best, neutral. The French are discussing cuts in public spending and in Germany different new taxes are about to be introduced. The pro-cyclical stance of fiscal policy of these governments gives additional reason for concern. Fiscal policy is limited by the Stability and Growth Pact. Although the EU Commission presented a new set of rules to allow for a more appropriate interpretation of the Pact, in the short-term, it does not provide much room for flexibility for either Germany or France.

Based on CSFB's adjusted pre-goodwill basis, consensus EPS growth rate estimates for Continental Europe is around 20% for 2003 and 14% for 2004 whereas we saw -4.4% in 02 (UK: 13.2% for 03 compared with -4.3% in 02). An estimate around 5-10% would be more realistic and hence these estimates are at risk of being lowered. Hence, we expect more downgrades to come at least in the 1H 03. Unless earnings expectations start from more realistic levels, markets will fail to derive support from improving expectations. In addition, prospects of war are still looming over the 1H 03.

A possible way to play such a market is through dividend paying stocks. European equities yield now 3.5% compared with 3% as a 15-year average and 2.6% a year ago. BNP Paribas (BNP FP, EUR 40.4), Stora Enso (STERV FH, EUR 10.65), Arcelor (LOR FP, EUR 12.08), Eni (ENI IM, EUR 15.547) and TotalFinaElf (FP FP, EUR 138.40) offer all a relatively attractive dividend yield. Eni and TotalFinaElf represent in addition a hedge against a Gulf war.

A sector which we continue to like among the defensives is the pharmaceutical sector. Despite being a defensive sector showing non-cyclical growth it has often outperformed a rising market. We like Aventis (AVE FP, EUR 53.6), Sanofi-Synthelabo (SAN FP, EUR 58.1) and Roche (ROG VX, CHF 100.75).

Among the defensives, we also continue to like food producers such as Nestle (NESN VX, CHF 306).

In the short-term, hope for a boost to growth lies with the ECB. We believe interest rates still have room to go down within the 1H 03 although we do not expect the ECB to already act on this Thursday's meeting. However, according to the OECD model, each 0.5% cut adds only 0.1 - 0.2% to real GDP. The limited power of monetary policy comes from Europe's smaller household sector debt as a % of GDP (around 47% in Europe compared to around 77% in the US). Further, lower interest rates increases the present value of future pension liabilities.

In case rates fall more than expected, cyclical stocks - which performed on the sidelines during most of 2002 and tended to lag the recent bear market rally we saw in October - such as Stora Enso (STERV FH, EUR 10.65), Arcelor (LOR FP, EUR 12.08), Adecco (ADEN VX, CHF 56), JCDecaux (DEC FP, EUR 11.83), LVMH (MC FP, EUR 41.02), DaimlerChrysler (DCX GY, EUR 30.81) and technology and telecom stocks such as SAP (SAP GY 85.85) and Vodafone (VOD LN, GBP 1.1825) are set to perform well. Further supportive for cyclicals are the 1Q seasonal effects, which historically appear to be greatest for cyclicals.
Banking stocks such as BNP Paribas (BNP FP, EUR 40.4) may also benefit from lower ECB rates.

However, we see two possibilities for a more optimistic view. If political and earnings risk peak in early 2003, ECB cuts rates aggressively and the global economy shows sign of a recovery, we could see sentiments improving. Although we do not expect a sharp rebound in productivity or output, we could see the overall picture improving in 2H of 03. The other possible silver lining also comes from the impetus for structural reforms that a strong Euro provides. If yen weakens as a result of Japanese policy measures and if the US dollar continues to weaken in line with its domestic fundamentals, the burden of exchange rate adjustment would fall disproportionately on Europe. European corporations can accommodate such a strong currency only if structural reforms mitigate their operating costs in other areas (e.g. labour compensation). Thus a strong Euro, if it results in accelerated structural reforms and much lower interest rates, could lead to a re-rating of European equities.