Recent economic indicators confirm the outlook of strong, synchronised economic growth. Strong growt...
Recent economic indicators confirm the outlook of strong, synchronised economic growth. Strong growth would normally fuel inflation pressures and prompt central banks in the major economies to raise interest rates, to the detriment of financial markets. However, the markets have not behaved as one might expect.
Inflation data from the US has been better than expected. There has been some evidence of rising prices, with increases in oil and other commodity prices feeding through to higher producer prices. However, even with the current low levels of unemployment in the US, wage pressures have been remarkably subdued.
In November, the European Central Bank (ECB) raised euro short-term interest rates by 50 basis points. This move was larger than most commentators expected but was received well by investors who viewed it as pre-empting a pickup in inflation and allowing rates to remain stable for the foreseeable future. Equity and bond markets have rallied in response to the news from Europe and the US.
The possibility companies may experience disruption to systems at the turn of the year due to Y2K is adding to the unpredictability of the markets. So far, there are few signs that markets are anticipating any ill effects - otherwise, we would expect investors to exhibit a marked preference for cash over equities. Nevertheless, the possibility of Y2K disruption remains, and this adds to the uncertain economic environment.
On a regional basis, we favour European equity markets for our managed portfolios. We forecast GDP growth for 1999 of 2.3%, followed by 3.0% growth in 2000. While growth is recovering sharply, there appears to be enough spare capacity to ensure inflation does not pick up much. The ECB rate rise has dispelled uncertainty about the economic outlook, while profit growth is strong and equity valuations look reasonable. In addition, international investors who favoured Japan and the Far East at the expense of Europe earlier this year are now beginning to return to Europe.
The US economy continues to grow rapidly, although there are tentative signs of growth slowing. We expect overall GDP growth of 4% for 1999, moderating to 3% for 2000. Robust economic growth creates a favourable environment for corporate profits. With good economic conditions expected and profit growth likely to be strong, we are inclined to take a positive view on US equities. However, the current high level of equity valuations has tempered our enthusiasm.
As the UK economy has strengthened, we see evidence of inflationary pressures in the form of rising wages and producer prices, and house price inflation. Again, economic growth should present a positive environment for profits. However, domestic profitability is under pressure with companies finding it difficult to pass on rises in input costs to final consumers. Profit growth in the UK is unlikely to match other regions, and interest rates will rise by more than those elsewhere.
We have decided to reduce our overweight positions in Japanese and other Asian equities. Profit growth in Japan will be good, provided the economic recovery holds up, and equity valuations do not look particularly stretched. However, it is unclear where the buying required to drive the equity market higher will come from. There is a similar situation in the Far East. The Asian recovery continues to gather pace as higher domestic demand adds to sharp growth in external trade. However, our shift to a less pessimistic stance on markets elsewhere - Europe and the US - means it is harder to argue the Pacific markets will outperform.
Alistair Byrne is head of investment strategy and research at Scottish Equitable Asset Management
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