The winning themes of 2003 have continued to make the running in the opening weeks of the current ye...
The winning themes of 2003 have continued to make the running in the opening weeks of the current year. Commodities, emerging markets, smaller- and medium-sized companies and technology have all made a firm start, while the more defensive areas have generally made little progress.
A similar pattern applies to bond markets, with investors demonstrating a continuing appetite for risk by showing a clear preference for emerging market and high-yield corporate bonds over government bonds. The latter have been held back by concerns over rising issuance and by the realisation that the interest rate cycle is gradually turning against them.
Although investors are in a more cheerful mood, in expectation of strong global growth and further improvements in corporate profitability, they will need to keep these assumptions under review. Investment is always a matter of balancing risks and rewards in the specific asset classes and geographical areas that contribute to a global portfolio. With optimism in the ascendant, paying close attention to potential sources of risk is especially important.
The world economy is expected to expand by over 4% in real terms in 2004, a return to the buoyant rates experienced in the best years of the 1990s. However, the potential risk lies in how this growth is being generated and in its uneven nature. On the plus side are ranged the US, with forecast growth of 4% in 2004, together with China, India and other Asian countries, whose economies are expected to expand by as much as 8%-10% in some cases. The tortoises, in a global context, are Europe and Japan, accounting for around 40% of total GDP, where recovery is likely take growth to near the 2% mark.
Two matters on the economic front need to be watched closely. While inflation has remained generally benign, exceptional demand has driven up prices of many commodities, especially metals, and this is bringing some pressures to bear, especially in China. Inflation there has risen to about 3.5%, prompting the authorities to take action to ensure that maintaining strong economic growth does not result in intolerable pressures on the financial system and infrastructure.
Steps have been taken to deal with bank bad debts and it is widely believed that, at some stage, the Chinese currency will be revalued by pegging it to a basket of currencies, rather than just to the dollar. Export growth from China depends on continuing healthy demand, especially from the US. Any protectionist measures from that country could have unfortunate consequences.
The second issue arises from the imbalances, especially the burgeoning current account deficit, created as a consequence of aggressive action taken to boost the US economy. This has led to the slide in the value of the dollar, especially against the yen and the euro, which could threaten recovery in those two key areas.
Asian countries now hold over 70% of world foreign exchange reserves; heavy buying by them of US treasury bonds has prevented the decline in the dollar becoming more severe. Despite the comment on currency fluctuations in the communique of this month"s G8 meeting, the risk of further sharp falls in the dollar and of unwelcome gains in the value of the euro and the yen are still significant. A currency crisis (defined as a sharp fall in the dollar) would set alarm bells ringing in the mind of investors, pushing up yields on US Treasury bonds and could dramatically diminish their current healthy appetite for risk.
Aside from the economic picture, the other key determinants of market opinion are the way in which the corporate sector is faring. The US reporting season for the final quarter of 2003 has largely been concluded. As far as profits were concerned, over 60% of companies at least met forecasts, thanks to cost cutting/restructuring, the impact of the lower dollar on overseas revenues and some benefits from the buoyant domestic economic background.
However, investors generally took a neutral view of these, choosing to pay more attention to the tone of statements on the trading outlook. Only CEOs issuing optimistic trading statements saw their shares gain ground. This illustrates the extent to which the US stock market, with its current year price earnings ratio of around 19 times, is already pricing in a solid profits recovery.
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