2005 – Another year of living dangerously?
It has
been an interesting twelve months, and it is pleasing that most of our
predictions for 2004 came to pass (copies of January 2004 Newsletter available
on request!).
Throughout the year we worried about
global financial imbalances and economic risk, but it proved correct to continue
to have faith in equities and a total return strategy. The resilience of the
global economy has been impressive. The massive spike in oil prices at a time of
financial disequilibrium, high debt levels and tightening US monetary policy had
little impact. Meanwhile, in China the authorities appear to have successfully
avoided an economic hard landing.
We continue to worry about the unstable
global situation, especially with the US Dollar in potential free fall. We fear
that there may be a high price to pay for the massive reflation of recent years;
but we also acknowledge that there have been concerns about debt for several
years and that, so far, nothing untoward has come to pass. Central Banks and the
global financial system do seem to be able to maintain today’s precarious
position better than in previous decades – but for how long?
Once
again we will stick our necks out to make predictions for 2005:
- The
global economy will grow, but more slowly.
- Commodity prices will
remain firm in the first half but tough competition will keep the lid on general
inflation.
- The downside for the oil
price is limited from current levels.
- Gold will be vulnerable to
Fed tightening.
- The
US Federal Reserve will move interest rates steadily towards 4% (although the
peak may be lower than expected and may not be reached in 2005).
- The European Central Bank
will cut rates, as will the Bank of England.
- Bonds look fully valued,
but benign inflation and a high level of savings will keep yields low.
- Equities might be unnerved
by Fed tightening but should still outperform bonds.
- Large cap stocks will
start to outperform smaller companies.
- The Dollar is due for a
bounce, but the bear market has further to run. Its role as the global reserve
currency will not be threatened.
- The lower Dollar will
sustain US growth.
- The Chinese economy will
remain vigorous and continue to drive global growth.
The good thing about all of
the above is that nothing should come as much of a surprise – markets hate
uncertainty. Provided that Asian central banks remain buyers of Dollars and the
US does not have to compete for capital, then financial imbalances can be
sustained for some time. It is too early to worry about US debt; policymakers
still have some scope to push the Dollar lower and the Fed can always cut rates
again if the economy slumps.
In terms of risks, the
geopolitical one remains the most troubling and hardest to quantify. Oil could
surprise on the upside, as could inflation.
The effects of reflation are
dwindling and defensive plays will become more relevant next year. With global
earnings momentum fading, 2005 may not be a vintage year. But we think that much
of the likely bad news has been discounted and that equities, relative to bonds,
look nearly as cheap as in early 2003 when the recent bull run started.
We will continue to ‘hunt
for yield’ and have increased our equity weighting by 2% at the expense of bonds
and cash. We have increased our position in North America (which has been
underweight), and increased exposure to the Pacific Rim and Emerging Markets.
