For financial and commodity markets, 2004 was a year of extremes. Oil prices reached a 20-year high,...
For financial and commodity markets, 2004 was a year of extremes. Oil prices reached a 20-year high, soaring beyond $50 per barrel amid widespread political uncertainty and disruption to supplies. The dollar tumbled to its lowest level in a decade against major currencies. In turn, this helped to drive gold above $450 per Troy ounce, a 16-year high.
Stock market volatility declined to historically low levels at index level and stock level, as the difference between the best and worst-performing shares narrowed significantly. Just before the US election, the S&P 500 moved within an 8.9% range - the tightest since 1967 - while the FTSE All Share's 9.3% range was the narrowest since 1963.
The US election cleared some of the uncertainties that had clouded markets for much of the year and November and December saved what would have otherwise been a lacklustre year for equity markets. Overall, the FTSE All Share rose by 9.2% in sterling terms and the S&P 500 rose by 9.0%, ending the year at a three-and-a-half-year high.
In the fixed income markets, the tightening of monetary policy in some countries caused yields to rise on short-term government bonds. Yields on longer-dated bonds, however, fell as fears about future rate rises subsided and uncertainty over the sustainability of economic growth increased. Elsewhere, the difference between corporate and government bond yields - the spread - continued to narrow, especially so in the high-yield bond market, where spreads fell to historic lows.
According to OECD leading indicators, economic growth may be slowing. The economic picture has evolved from last year's so-called 'soft-patch' in the US to a broader and more pronounced economic deceleration. The main driver behind this has been high oil prices.
Oil prices, despite having fallen from record levels, represent a key downside risk to the economic outlook and have begun to weigh on future growth estimates. However, region-specific factors are also at play and add to the uncertainty.
In the US, rising private debt burden is of concern, while in the UK, rising household borrowing poses a threat to consumer spending. Japan and the eurozone's economic growth remain reliant on export demand, which could slow markedly due to declining global trade activity and unfavourable currency movements.
In South Asia, economic and market news has recently been dominated by the tsunami, directly affecting 11 countries and causing the most widespread devastation in Asia since World War II. While the human and social costs are considerable, the aggregate economic impact is likely to be limited, especially when compared with the effect of the Sars epidemic in 2003.
The main affected industries of December's disaster are agriculture and tourism, not manufacturing. In most countries, the loss of capital has been limited to under 1% of GDP. Additionally, reconstruction activities are expected to boost investment demand in 2005 but the net impact on the affected economies and their fiscal positions depends on how such reinvestments are financed. Overall, the tsunami has had little impact on financial markets so far.
In western markets, income is likely to be a dominant theme in 2005 for both bonds and equities. Bond yields have tended to trade in a narrow range; in absolute terms, yields are historically low. Credit spreads are also narrow by historic standards. This background may imply bonds will provide an income rather than capital gains.
There also appears to be a growing awareness among investors of the importance of dividends when investing in equities, while there is a widespread expectation that capital gains will be limited. At the corporate level, firms have record cash levels on their balance sheets, and this could generate attractive investment opportunities for bottom-up investors. Stock pickers can select those companies that are likely to use this cash to reward their shareholders, either through increased dividends, or through share buyback programmes.
In the current environment of low price index performance, dividends are likely to become an increasingly attractive component of total returns. In addition, stock valuations at their current level are affordable. Easy access to finance could also spur a revival in M&A activity.
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Cautious welcome for volatility