With financial market uncertainty on the rise, HSBC Investments recommends overweighting equities, favouring Europe and the U.S.

“After many months of strong and stable market conditions, uncertainty has started to rise again,” observes HSBC in a new report. “The hot issue is the possible unwinding of carry trades. In the last couple of years, carry trades have consistently favored cheap assets.”

“The trajectory of future short rates has been consistently revised down and cheap assets have seen their value rise. However, economic developments now make it likely that rates will go up in Japan and the eurozone,” it notes.

“The most promising approach consists of sticking to a strict valuation discipline while keeping an eye on fundamentals,” it counsels. “Our strategy remains to overweight equities since valuations are sound and growth prospects are positive. The overweight remains in Asia and emerging markets. With the renewed strength in the Canadian market we continue to target a neutral weight.”

Bonds remain unattractive on valuation grounds, HSBC says. “But if U.S. long bond yields approach 5% and the U.S. economy does slow down then bonds will become more attractive,” it predicts. “At this stage we prefer to remain underweight.”

Looking at the asset allocation picture, HSBC says, “The most risky markets are the ones where valuation levels have been pushed too far. Some Middle Eastern markets are clearly in this camp.”

“In other cases, valuation remains reasonable but fundamentals are very poor, suggesting caution. In emerging markets, this translates into a large current account deficit and strong sensitivity to volatile capital flows,” it says. “In developed equity markets, the striking feature is that valuations have either fallen or remained stable. This reflects the lasting cautiousness of investors following the bear market. In particular, the low relative valuation of European stocks is striking. This suggests that these markets should provide decent returns.”

HSBC says that the outlook for the U.S. stock market, “remains constructive as growth remains solid, core inflation is under control, the peak in interest rates seems within sight and valuations are reasonable. While the concern that the Fed will raise rates too high is likely to remain a theme, we do not see it blocking the market’s further progress over coming weeks.”

For Canada, it says, “We continue to see evidence of a maturing economic cycle and as such expect earnings in Canada to moderate to the single digit range in 2006. Despite our positive long-term view of commodities, we have become increasingly concerned with the maturity of the economic cycle and the speculative nature in certain portions of these markets.”

“With positive earnings growth and only modestly higher interest rates, we continue to expect price appreciation in the equity market at a more modest pace than in recent years. We expect stock selection to be a key factor along with the quality of earnings,” it says.

HSBC says, in Europe, it continues, “to find attractive opportunities in companies that could benefit from restructuring, or that generate good returns and are able to reinvest productively.”

“Our analysis shows many European companies are undervalued. From a valuation perspective, the UK market is still attractive,” it adds.

In Asia, it notes, “Based on our expectation of domestic consumption and asset reflation as prominent themes for 2006, we like the consumer sector and consumer-related technology names. From a country perspective, we continue to favor the Korean market. While the market had a strong run last year, it remains fundamentally attractive given the improving economy and compelling valuations.”

“We also like the China market for the continued strength of its domestic economy and attractive valuations. We will reduce exposure to Taiwan, given rising political uncertainty. In Japan, a confirmed recovery should continue to improve earnings expectations, while market volatility creates good purchase opportunities,” it concludes. “Our sector allocation was kept unchanged with small changes in stock picking. Cyclicals are still favored because of higher expected returns and strong earnings momentum.”