Prospects for investment markets, particularly in the East, have turned a corner
As market participants return from their summer vacations to catch up on the developments in world markets, they could be forgiven for wondering, briefly, if they were still daydreaming on the sunny beaches of the Mediterranean.
The doubts about the pace of world economic growth which dominated investment earlier this year are a thing of the past, deflation is hardly mentioned any more, and the MSCI World Index is up 31% in US dollar terms from the March lows.
The investment climate has undeniably been a favourable one for equity investors, and this looks set to continue in the short term. We believe the prospects for world economic growth look very secure for the next three quarters, and are retaining our overweight position in equities relative to bonds. However, we are starting to wonder where economic growth is going to come from in the middle of next year, and may start to look more favourably towards bonds at that point.
For the past two years, the single driver of world growth has been the US consumer, helped by successive interest rate reductions, and the opportunities this has afforded to re-finance home mortgages at attractively low rates. Lately, almost all economic data in the US has been coming in ahead of expectations, with retail sales proving particularly strong thanks to President Bush's tax cut. The question mark from here is whether the sharp rise in bond yields we have seen over the past couple of months will choke off growth in the interest-rate sensitive areas of the economy.
We believe the combination of tax cuts, some modest employment growth and a pick up in capital spending by companies will be sufficient to drive the economy quite powerfully over the next three quarters. After that, the drag from higher mortgage rates will probably start to act as a cap on growth. This makes it harder for us to make the relative valuation case for US equities, and once optimism in the market gives way to triumphalism, we are likely to begin to reduce our exposure for balanced portfolios.
Instead, our attention is increasingly focused on the East. We continue to favour emerging markets globally, and particularly some of the smaller Asian markets for the attractive combination of growth and value we can find there.
We have now complemented this by moving to an overweight position on Japanese equities. It has been a long time since we have held this view, and there have been many false dawns in the Japanese equity market. Yet, we feel that the fundamental changes we have seen there are having an effect.
Deflation, the vicious spiral of falling goods and services prices, is finally showing an improving trend. If we see this turn positive, the majority of any increase in prices should drop straight through to profits for companies after the cost cutting we have seen in recent years. It is unlikely to be a smooth ride, but we believe the long-term prospects for the market are brighter than for many years.
Percival Stanion, Chairman, Strategic Policy Group, Baring Asset Management, London
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