European equities have had a bad year and U.S equity markets are still under pressure (page 1 of 3)

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%.