Baring Asset Management (BAM) says three factors have changed on the economic front which will have huge significance for investors this coming year.
First, and most important, monetary policy in the US has moved to a tightening mode, along with the UK, Canada, Switzerland and Australia. Second, commodity prices, particularly oil, seem to have established a new firmer trend. Third, the US dollar, after a year’s pause, has resumed its downtrend.
It is hugely significant, says BAM, that the Federal Reserve has begun a process of “normalising” interest rates, meaning a measured rate of increase, from what can only be viewed as “emergency” levels. As most markets have weathered this change in monetary policy it implies that investors accept the world economic cycle has moved into a more normal stage of moderate, but sustained expansion.
“2004 was a year of transition”, says Percival Stanion, BAM’s Head of Asset Allocation, “and interest rates are still barely above inflation in most countries with the notable exception of the UK. We are likely to see increased corporate activity as companies gear up their balance sheets, and higher dividends as cash flows remain strong. But the downside is that inflationary pressures could spill out from the commodities sector to other areas such as wage growth in the US and UK.
With this in mind, BAM believes 2005 could be a good year for equities, but a more challenging one for conventional bond holders. Percival Stanion explains: “If the world has passed the peak rate of change for industrial activity, but is still showing sustained moderate growth, the prospects for equities relative to other asset classes should remain positive. Current bond prices in particular simply do not compensate for the risk that inflationary forces start bubbling away under the surface.”
Geographically, BAM believes that returns in 2005 are likely to be best from Emerging markets and Hong Kong, followed by Singapore and Australia. BAM is cautious about the US market and has a relatively neutral outlook for the Eurozone, Japan and the UK.
Percival Stanion comments: “In our view, Asia still offers the best growth potential, and this may become more marked in the year ahead as investors become more relaxed about the outlook for China. Indeed, with easy monetary policy no longer the order of the day in the West, the higher growth rates available in Asia are likely to be thrown into stark relief as the year progresses.”
BAM favours countries around the Pacific Rim that will benefit from China’s continued industrialisation, with the added potential bonus of a Chinese currency revaluation at some point this year. Japan could also be a beneficiary of this once capital goods exports pick up again.
The two main Anglo Saxon equity markets, however, hold less interest for BAM. “Although the UK market is relatively cheap and has a good dividend yield, and the mid cap sector will probably also benefit from merger and acquisition activity”, warns Stanion, “many overseas earners in the FTSE 100 are suffering from the weakness of the US dollar. Once UK interest rates start to fall and Sterling gives up ground, this headwind will reverse, but the first half of 2005 could prove difficult for UK investors”.
Meanwhile, BAM remains underweight in the US equity market, which is more expensive than the rest of the world. The large pharmaceutical and financial sectors both are under pressure in the US, and although technology sector could be a bright spot in 2005, even here BAM find valuations still rather expensive and would look for lower entry points.