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A transition year shapes up

World economic growth contracted from 3 to 1.5% in 1998. The emerging markets crisis put a dampner on economic activity and sent commodity prices into a tailspin.
Economic rescue packages were largely what the markets hoped for.
Interest rate cuts were lead by the Fed and political leaders made an effort to stem the effects of the crisis. When could world economic growth pick up again? Late last year, fears of deflation were receding in developed economies. However, the crisis in the emerging markets has still not been fully resolved, as evidenced by recent events in Latin America.
For this reason, 1999 is shaping up as a transition year.
The surprising component of US economic growth in 1998 was the strength of consumption. In 1999, growth is expected to slow to 2.1% compared with 3.6% in 1998, a mild slowdown underpinned by con-sumption and a subdued inflation. Manufacturing looks set for a sharp slowdown and a margin squeeze. Domestic demand remains very weak and confidence indicators are still pointing downwards.
Economic policy is focused on reflating the economy, but the measures taken so far have been insufficient to lift the economy out of its recession.
After contracting by 2.8% in 1998, the Japanese economy is expected to spend another year in recession (1%).
The euro-zone is expected to see growth of 2.2% in 1999. A rate of inflation below 1% has a positive effect on the purchasing power of European consumers, who are benefiting from interest rate cuts. Compared with the US, Europe has a high savings ratio, due to high inflation, fiscal austerity and high levels of unemployment.
Euroland economic policies are now focusing on tackling the high levels of unemployment. This could give a further fillip to consumption. Despite international aid packages, Russia and Brazil are still risk-generative. Latin America is expected to slip into recession, and the region's currencies will weaken. A move from fixed to floating exchange rates should allow interest rates to fall but in line with the devaluation of the Brazilian Real now that investors have once again lost confidence. In Asia, some countries are emerging from recession while others are still in serious difficulty.
Central banks are conducting monetary policy within a flexible framework. The inflation will be low helped by commodity prices. The US and Europe could respond by further reductions in interest rates. Meanwhile, misgivings about the US dollar could prompt central banks to intervene in an effort to stabilise the major currencies.
There is still ample liquidity in the world economy, and central banks are unlikely to go back on their recent injections.
Portfolio reallocations can be sudden, and financial markets are still highly volatile.
The decline in long rates will be sustained by a slowdown in activity and risk aversion. The euro-zone bond markets benefited from asset reallocations. This is likely to continue as international investors seek to increase their exposure.
The euro is having a positive impact on European industry. A combination of competitive pressures and the search for higher productivity is putting pressure on company management, to the advantage of shareholders. Transnational mergers will continue. Equities are attractive in the longer term due to the positive effects from the introduction of the euro and increased aggressiveness to US firms. The crisis in Brazil will once again increase risk and reduce earnings visibility, but the decline in long rates should support equity market valuations. Consequently, the investment strategy for our Euroland portfolio places an emphasis on equities rather than fixed-income.
Euro-zone equity markets are more attractively valued than their counterparts in Europe and the US.
As regards fixed-income, European markets provide a better environment. The Brazilian crisis could set in train further cuts in US rates followed by further cuts in European rates.
Patrice Gautry heads the economic and strategy department at CCF Capital Management in Paris

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