LONDON, 10 January 2005 — Lower oil prices and a clear US election result boosted investor sentiment in the closing weeks of 2004, despite a sharp decline in the US dollar, which could have unsettled markets.
The US election result seems to have encouraged investors to deploy some cash. With Republicans now in control in Washington, Wall Street is discounting some improvement in the tax treatment for equities. There are proposals for extending, or making permanent, previous cuts in dividend and capital gains taxes. US workers may in future be allowed to invest a proportion of their social security contributions directly into the stock and bond markets.
US leading economic indicators rose in November for the first time in 6 months and most statistics suggest that the US is continuing to grow at a reasonably rapid rate — say around 3.5 percent. Mainstream forecasts project this sort of growth continuing into 2005, with the economy expected to be rather stronger on the corporate side than in the consumer area. The US consumer is heavily indebted and job growth remains meager, which in turn weighs on confidence. Corporate sentiment, however, is buoyant because profits and cash flows are good. This bodes well for investment spending going forward.
We, however, expect somewhat slower growth in the US in 2005. The budget deficit is very large and measures to cut back on government spending seem likely. We are skeptical that the US dollar can achieve a soft landing given the ongoing (6 percent of GNP) external borrowing requirement of the US. The risks are high that financial market turbulence will have a negative economic impact.
Outside the US, the signs of slowdown are more evident. The strong euro is hurting many European companies. In Japan, the combination of terrible weather for much of 2004 and a strong yen seems to have depressed business investment quite sharply — though here the fall-off has been so steep that a near-term rebound is widely expected.
In the background is the suspicion that the Chinese economic growth rate is unsustainable and that the “landing”, when it comes, will be “hard”. Nevertheless, slower world growth, as opposed to impending recession, remains our forecast for 2005. On this basis we don’t see a serious inflation threat developing — even though inflation hedges such as gold, real estate or inflation-linked bonds — may well continue to figure more prominently in many portfolios.
Our asset allocation remains a cautious one. The huge US current account deficit carries with it the potential for financial market instability. Also, with securities market volatility now very low, the betting must be that it will rise from here. (Even though the volatility index for US stocks defied predictions and continued to fall in 2004).
We stick with our 25 percent commitment to equities. While we expect stock markets will continue to do well in the short-term, we don’t see conditions in place for a sustained good performance from the equity markets. Valuations are still high and corporate earnings growth is slowing.
Bonds continue to represent the largest component of portfolios — at 45 percent. While we do not look for any trend decline in yields, we still consider that the spreads offered by non-investment grade securities are attractive. Elsewhere, we stick with a 25 percent allocation to alternative investments — mainly in low-risk fund of funds investments. Cash, at 5 percent, is kept near the minimum.
While we expect equities to do reasonably well in the near-term, we don’t look for strong returns (i.e. over 10 percent) in 2005. Whereas a year ago we had a strong overweight in energy, no single sector seems particularly compelling at the present time. That said, we remain overweight in energy, although to a smaller extent than before. Other emphasized sectors are biotech, telecom services and utilities.
We stick with our low risk policy with respect to duration but with a strong commitment in the higher-yielding, non-investment grade area. This month we have extended our exposure to US inflation-protected bonds and have cut back slightly on duration in European bonds.
Finally, the US dollar has fallen substantially in the fourth quarter and we are reluctant to predict an immediate further decline, even though our macro-economic forecasts suggest further downside in 2005. Our favored currencies are the yen and sterling. We have become more negative on the Australian & Canadian dollars.
(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.)
