America has attacked Iraq with support from a large number of countries but without the backing...
America has attacked Iraq with support from a large number of countries but without the backing of the United Nations. This outcome was rather less market-friendly than the one that we had anticipated but the markets have conformed to our predictions nonetheless ' the oil price has dropped sharply, equities have rallied, bonds have fallen and the dollar has started to recover. Although the market environment remains one of high risk, the early signs are that the commencement of hostilities marked a major turning point for the markets.
The good news is that the falling oil price (it is down around 25% from its recent peak) will lead to better inflation news during the next few months. The bad news is that if (as we expect) the global economy recovers strongly as a result, the medium-term trend for inflation is likely to be less favourable.
Phase one of the equity bear market ended in October 2002 and we expect phase two to unfold during 2004.
The sharp rise in equity markets during the late 1990s represented a speculative 'bubble' along the lines of those experienced by Wall Street during the 'roaring twenties', the Nikkei during the 1980s and the gold price during the late 1970s. In all of these cases, 'boom' was followed by a long period of 'bust'. Thus far, the American stock market has experienced a decline that has lasted three years and has taken share prices down by roughly 50%.
Historical comparisons suggest that share prices may have further to fall over the long term. However, they also support the idea that October 2002 was an important low for the NASDAQ (the main 'bubble' market). Having corrected its October/November gains without testing the low again, the Nasdaq appears to be resuming its uptrend. Most stock markets around the world have followed roughly the same pattern ' falling during December/March before rising more recently. Nevertheless, many non-US indices slipped to new lows in the recent downswing due largely to the weak dollar. Share prices should continue to move erratically higher until their next peak in 2004.
The stock markets of Europe have historically outperformed when the euro or its forebears have been weak. The euro has recently weakened versus the dollar and indices like the German Dax and French CAC40 have significantly outstripped their American counterparts. These markets remain cheap in comparison with Wall Street and should continue to outperform, with the proviso that the euro continues to weaken.
Bond markets have recently fallen sharply around the world and it is looking increasingly likely that the cyclical peak for prices is finally in place. European bonds are likely to outperform their American equivalents during the bond bear market as the inflation differential between Europe and America widens.
Inflation-linked bonds always tend to outperform their fixed income equivalents during periods of falling bond prices. However, having (somewhat unusually) outperformed fixed income securities during the last period of rising bond prices, this rule may not apply in the immediate period ahead. Furthermore, the recent fall in the oil price may lead to some softening in investors' inflationary expectations.
The prices of gold and other commodities have risen sharply during the past few months due to supply considerations and/or the weak dollar. However, commodity prices have probably entered a period in which they will move either sideways or down (the gold price is already significantly below its recent high). The dollar has almost certainly bottomed for the time being and there remains considerable concern regarding the health of the global economy. However, the recent drop in the oil price should help to foster a solid economic recovery and real interest rates remain very low by historical standards ' both factors suggest that any weakness in commodity prices should be short-lived.
The currencies of commodity-producing countries such as Canada, Australia and New Zealand have been among the best performing in the year to date. However, they are technically overbought (having moved too far, too fast) and should experience a period of consolidation before eventually heading higher later in 2003.
Peter Lucas, Global Investment Strategist, Ashburton
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