LONDON, 6 December 2004 — Financial markets have moved powerfully over the last month. Global stocks rallied in the wake of the US election results, which not only returned George Bush to the White House but also gave the Republicans a more clear-cut control of Congress. Many investors now anticipate that shareholder-friendly legislation will get through the new Congress. Possible measures include making recent tax cuts permanent. There are also proposals to allow workers to invest a portion of their social security contributions directly into stocks and bonds.
The immediate response of the US bond market has been negative, perhaps because bond investors sense that a Bush administration will be less aggressive in reducing the Federal budget deficit than a Kerry administration would have been.
Of more economic importance is the continuing rout of the dollar, which is regularly setting new all-time lows against the Swiss franc and euro. Many investors are worried about the potential for a further decline. Specifically, there are doubts that Asian central banks will continue willing to accumulate the dollar assets, which accrue naturally through the huge trade surpluses that Asian economies have with the US. Almost all published forecasts now project a further dollar decline in coming weeks and months.
We think that the dollar’s continuing decline is likely to increase tensions elsewhere in the financial markets rather than reduce them. The risk is that, as the dollar falls, investors may perversely require higher US interest rates in order to hold dollar assets. (Even though a cheaper exchange rate implies an increased chance of a currency gain and should theoretically prompt investors to accept lower interest rates on their dollar assets).
So far as the immediate impact on demand is concerned, the weaker dollar will tend to support economic activity in the US — most obviously, at the expense of Canada and, to a lesser extent, Europe. Such reasoning may explain why while yields in Euro-denominated bonds have fallen over the last month when US bond yields have risen.
Many Asian currencies are, for the time being at least, moving alongside the US unit, so competitiveness in this region is largely unaffected. In any event, countries such as India and China have such a huge cost advantage over industrialized countries in many lines of business that it would take an enormous revaluation of their currencies to seriously impact investment inflows into the region. With the US election results now known, we upped our equity allocation back to 25 percent. Although we are optimistic that equity markets will perform well in the near-term, we have longer-term concerns about the valuation and earnings prospects. We retain a 25 percent allocation to alternative investments, a 45 percent position in bonds and a minimal (5 percent) cash position.
We reduce the number of showcased sectors to three — energy, biotech and utilities. This decision is largely driven by a desire to spread our equity exposure more widely. In relative sense, telecoms, luxury goods, industrials, finance and materials all have some attraction at the present time. Meanwhile the removed sectors — health care and staples — enjoy relatively stable demand patterns.
Our allocation in the alternative investments area consists chiefly of low-risk fund of hedge fund products. If markets start to exhibit stronger trends and greater volatility, these hedge funds should start to perform better, following a lackluster performance in 2004.
Although we are reluctant to call for a further dollar decline in the near-term after such a steep fall, the pressures for further dollar depreciation remain in place. Of the major currencies we are most positive on the yen. Within Europe we project some appreciation of sterling against the Euro and the Swiss franc.
(Habib F. Faris is vice president at Clariden Bank, London.)
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden bank makes no representation or warranty as to the accuracy, reliability, or completeness of the information.)
