Keith Wade, chief economist at Schroders, Michael Karagianis, head of Global Strategy at Aberdeen Asset Management and John Hatherley, head of research at M&G, talk to Caroline Allen about what investors can expect in the year ahead
CA: Let's get a general outlook first. Markets have surged in the last few weeks, but is this the start of a sustainable rally for 2002 or another false dawn?
Keith Wade (KW): It looks like the US is firming a little, but US economic data released in December, which showed renewed consumer spending, might be more of a correction to the downturn than the start of a prolonged rally. I am not entirely convinced we have got to the turning point. My concern is that we see a bit of a setback before a real recovery. The first quarter of 2002 may prove to be difficult.
John Hatherley (JH): The global outlook hinges on the US, which is the only economy with sufficient domestic demand to generate growth. There are a number of factors supporting the consensus for a recovery through 2002. Interest rates, led by the US Federal Reserve, have come down dramatically. Central banks, again led by the US, have been injecting liquidity into the markets and governments are using fiscal policy. A weaker oil price is also helping some economies.
Michael Karagianis (MK): People underestimate how long the slump has been going on for. Essentially it has been around since the middle of 2000. It is unusual for this type of downturn to last more than 18 months. We have had a deep inventory unwind in the US. Early industrial production could bounce back quicker than people think, but that often leads to expectations of a sharper recovery than is ultimately fulfilled.
CA: So perhaps a recovery, but not just yet. What do you perceive as the risks to a rally through next year? Some commentators are talking about over-heating.
MK: We have had a raft of doom and gloom articles, then there is talk of overheating which is a bit odd. In the US, we have been surprised by the volume of retail activity, but there is intense discounting to bring that about. That is not a sign of overheating, but of retail outlets struggling to encourage people back into the shops.
KW: In the UK you are looking at GDP of about 2%. The Bank of England is of the view that some growth is better than no growth. If it were to stop that consumer boom, we would not have any growth at all. The worry, although not an immediate one, is that if you are the strongest economy and consumer driven, you end up with a big current account deficit.
CA: What about some of the other risks to a more bullish outlook in the medium term?
KW: One of our concerns is corporate profitability. If we get the turnaround in the world economy, that will help lift corporate profitability, but there has been this tremendous squeeze, particularly in the US. I am looking for profits to start to improve, but they have to come down further. Analysts' estimates for US corporate earnings are still very high. Earnings will improve, but I do not think they are going to get to the levels people are generally looking for.
Elsewhere, I do not think there are such great risks. The UK is a bit of an exception in this global cycle in many ways because it does have strong domestic activity in the form of the consumer and the housing market. After a bit of a lull in October these areas are coming back very strongly. That is great at a time that the world is in recession. It might mean the UK could avoid recession and prove to be one of the stronger growing areas.
CA: Do you see any particular risk from recession in Japan, as the world's second largest economy?
JH: Japan seems determined to do its own thing. There are continuing deep structural problems partly and primarily due to the banking system. Japanese stock market rallies have been a lot shallower since September than others around the world. That may reflect their own special problems, but we see Japan facing further severe problems in 2002. In a sense, Japan has been largely marginalised, but that does not preclude other economies doing rather well.
CA: Is a devaluation of the yen likely?
KW: Devaluing the yen is seen almost as a last resort for Japan. There would be some complex effects given the state of the banking sector but if it did fall it would certainly help. Unfortunately, there is a zero sum game where Japan's gain would be the loss of the US and other economies in Asia. The US might be prepared to see the yen at 140 to the US dollar. The problem is that when a currency starts to fall, it can fall very sharply. There is no such thing as a controlled devaluation.
MK: I cannot see the currency as a decisive factor in Japan. With global recession and negative trade flows, competitive devaluations don't help a great deal. In fact, the yen could be stronger than people think. Many investors are underexposed to yen assets at the moment. The equity market has been in a bear market phase for longer than most other markets and occasionally it surprises on the upside. Japan has many world-class export-orientated companies that are a leverage play on the US economic cycle.
CA: Will there be any fallout from the introduction of the euro on 1 January?
MK: A few months ago many people felt the eurozone would be immune to the economic slowdown. That has completely unwound now. Germany is in recession and the rest of Europe could be dragged down as well. Our prognosis is that Europe will probably have to wait for the US recovery to come through. That means a lag of perhaps one to two quarters. We could still be dealing with softer economic data through the first quarter of 2002 and hence interest rates will have to go a lot lower than many people expect.
KW: I cannot see any effect from the introduction of the euro. The big question over the long term is whether the single currency will bring the benefits Europe wants in terms of a more transparent market and the economies of scale of its US counterpart.
JH: I would agree it is a political, rather than economic factor. But the euro has already had an impact by deepening eurozone capital markets, an important driver of the growing equity culture and the restructuring process of European corporates. Having euro notes in people's hands is also strengthening their commitment to the currency. If the whole project is seen to be doing well, that could increase commitment to the currency.
Following from that is the issue of what happens to the UK and sterling. There are important investment implications if it looks like the UK will be joining the euro.
CA: Global bond markets have benefited from low inflation and falling interest rates, but where do they go from here?
JH: There is no one answer on the bond market -' I see it fulfilling a role, but a different role from the one it has over the past year. In the months up to September 21, which I date to be the bottom of the bear market, investors were searching for safe havens. Cash, government and investment grade corporate bonds had a very important defensive function. But now we are in a different environment. The role for defensive assets is going to be more subdued.
Another issue is that in a era of low interest rates and low return on cash there will be a search for income, with more emphasis on dividends in the equity markets and more emphasis on alternative sources of income to cash, such as government bonds and investment grade corporate bonds. I think high yield corporate bonds are interesting going forward. Given that they combine some gearing towards optimism on the equity front - typically they can command yields of anything from 8% and above, they could have a very good run in 2002.
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