LONDON, 9 January 2006 — As we moved into a new year, the world economy appears reasonably robust. The US has been growing around 3.5 percent — 4 percent for nearly 2 years. Japan’s recovery has taken on a steadily more sustainable character. Even Europe has started to firm — although the improvement is more evident in opinion surveys than in published data for spending and output.
Economic growth has encouraged central banks to raise rates. These started to rise in the UK and Australia in 2003. More importantly, the Fed began hiking in the second quarter of 2004. Relative to the 1 percent Fed funds rate at the start of the Fed tightening process, US rates have now increased by 325 basis points. As recent Fed minutes have hinted, we must be nearer the end of the US tightening cycle than the beginning.
In Europe, the ECB has recently started to tighten — with a 25 basis point move at the beginning of December. We don’t have much history to guide us on the ECB as it was a creation of the 1990s. Nevertheless most analysts predict a series of ECB rate hikes next year. In Japan, we may see an end to targeted expansion of the money supply in the next fiscal year, but that does not mean that official interest rates are set to rise.
We are optimistic that the world economy will withstand higher rates with the growth process still intact. That said, some reduction in the US growth rate is likely given the slowdown in housing and the impact of higher oil prices on consumer spending power. Also, we would be surprised if Europe accelerated much during 2006 relative to the 1.5 percent growth which is likely to have occurred in 2005. Consensus forecasts show a growth rate around 2 percent for Japan for the coming year.
This economic outlook is broadly positive for equity markets. Ongoing expansion suggests there is scope for further growth in company earnings — even though the rate of rise in earnings is unlikely to be as strong as it was earlier in the expansion process. More importantly, if (as we suspect) we are nearing the end of the process of Fed tightening then markets will probably move to value equities more highly. There is a chance, indeed, that equities be revalued at the expense of other asset classes. It could be that bonds become vulnerable to such a shift.
This outlook assumes that the imbalances in the world economy do not play out in a way that fundamentally undermines the growth process. The biggest imbalance relates to the US, which is the world’s largest debtor by far and the Asian economies that generate much of the world’s savings.
Most commentators view a growth process, whereby the US adds annually to its indebtedness an amount equivalent to 7 percent of its GDP, as unsustainable. However, this imbalance has gone on for several years and may therefore continue for a while longer. In the meantime higher US interest rates should support the international demand for dollar assets and help the US to attract the necessary inflow.
A second uncertainty is the potential for an energy “supply shock”, bearing in mind the tight supply situation. A further widespread concern is the highly investment dependent growth process in China. A fall-off in demand could reveal in a lot of overcapacity in the hands of highly leveraged companies.
Generally speaking, we believe that the growth outlook is good enough to justify continuing with our 35 percent weighting in equities portfolio. Given our low risk approach, the equity commitment is unlikely to be much higher. A further 35 percent is allocated to bonds. This represents a 5 percent reduction from last month. Bonds are an insurance policy against very negative economic developments. Nevertheless, we see little scope for a further reduction in credit spreads this cycle. Also, with interest rates still rising at the short end, we see little near-term attraction in long-dated bonds. Elsewhere, we retain our 20 percent commitment to alternative investments and have a 10 percent cash position.
Finally, and while energy remains a core component of our equity portfolios, we no longer predict near-term outperformance and have removed the sector from our favored list. We suspect that “higher-beta” areas such as emerging markets and biotech will lead further market advances in the near-term. Nevertheless, we continue to advocate a broad spread of equity investments across the main industrial sectors.
(Habib F. Faris is vice president at Clariden Bank, London.)
