LONDON, 7 March 2005 — The make-up of the world growth has changed substantially in recent years. Some of the fastest growing countries — China is the obvious example — now carry much more weight than they did. Indeed, the emerging market area as a whole is doing rather well. Growth in Latin America is more balanced, and hence sustainable, than before. East Europe is in some respects booming. There is the ongoing recovery of Asian economies, while high oil prices are obviously good for the oil producers in the Middle East and elsewhere.
All this means that OECD growth estimates substantially understate the overall rate of growth of the world economy. In fact, the world grew at a faster rate in 2004 than in over 30 years. Rapid growth outside the OECD area helps to explain why commodity prices — for oil, for industrial metals etc — are booming at a time when reported OECD growth is around just 3.5 percent.
However, the established industrial economies are also strengthening. In the US, business confidence remains strong according to survey data and capacity utilization is steadily rising. In recent weeks, the level of unemployment claims has fallen sharply, which suggests good US employment growth in coming months.
In turn, this should support consumer confidence and spending. It is worth nothing, also, the slight pick up in overall inflation. Obviously, raw material inputs — such as oil — cost more, but these cost pressures are now impacting the overall economy more strongly than before.
The European economy is not as strong as the US but the picture is an improving one. Also, business confidence in Europe is consistently stronger than the broader economic numbers — for example, the GNP statistics — would suggest. One part of the explanation, which may be relevant to Germany in particular, is that European companies do feel confident enough to invest but are doing so to an increased extent outside their home country, in Eastern Europe for example.
By contrast, the performance of the Japanese economy has been a disappointment. Technically, according to the GNP data, Japan has slipped back into recession. However, the data are hard to interpret because of the bad weather and typhoons last year and because the statistical methods have changed. There is a good chance that future data will show a recovery. However, it is troubling that reported data are not stronger given the booming world economy, and china in particular, and the strength and competitiveness of Japan’s export industries. All in all, there is nothing in these economic developments to suggest the Fed will stop raising interest rates any time soon. Forward yield curves are now pricing in an additional 1 percent of tightening in the US. While interest rates might rise slightly in one or two other countries — markets seem now to be expecting an additional 1/2 percent in the UK — we do not expect interest rises from either the Bank of Japan or from the European Central Bank in the next 6 months.
Given the expectation of continuing rises in US interest rates, our asset allocation remains for the time being a cautious one. When an end to US rate rises is more clearly in view, perhaps in the second half of 2005, we may well commit more heavily to longer-dated bonds and stocks.
We retain our 25 percent allocation to equities and the 45 percent allocation to bonds. Our bond exposure is short in both US and European markets. The 25 percent allocation to alternative investments is primarily in fund-of-fund hedge fund vehicles. The balance of the allocation — 5 percent — is held in cash.
We continue to favor energy as we expect energy prices to stay relatively high over the next several years. Elsewhere, we retain some focus on biotech and on telecommunications. However, we have removed utilities from our favored list, following good performance from utility stocks and in view of our expectation that this sector may be particularly affected by rising bond yields. We are skeptical that 2005 will be a year of dollar recovery and expect renewed US dollar weakness to trigger an appreciation of the yen in particular. Within Europe, we prefer sterling to the euro.
(Habib F. Faris is vice president at Clariden Bank, London.)