An uncertain 2005

Next year looks set to be another demanding year for asset allocators. Yields on fixed income are low, cash rates are low and equities are generally seen at best as at fair value. The prospects for returns on all asset classes are meagre.
Fixed income has been favoured as being in a regime where higher oil prices are not associated with the threat of higher inflation but perceived as a tax that is dampening economic growth.
The traditional negative textbook correlation between oil and bond prices has been replaced by more detailed reflections on the consequences of oil prices on the real and financial economy. This is a consequence of less dependence on oil in the industrialised world and a shift in the thinking of central banks, whose focus now is on the impact on growth and not inflation, as it used to be.
Short rates in the US have been kept artificially low to eliminate the small risk of deflation developing. The mission has been successfully completed and now it is time for a gradual adjustment towards rates that are more in line with underlying fundamentals.
This process is taking place simultaneously with a slowdown in the global economy, so there is a delicate balance between rate increases and maintaining a satisfactory economic momentum. This environment with higher rates and slower growth might be too demanding for the equity markets in general to produce promising returns.
On the other hand using the exclusion method the equity markets are the only place where there is a chance to get a decent return. Traditional cash positions and bond investments are bound to be low earners.
Given certain conditions being fulfilled, equities will appear as the most rewarding asset class in 2005. One of the more important conditions is a fall in oil prices. But that reduces the allocation process to a bet on future developments in oil prices. I am not convinced that oil prices are heading lower next year. The shift in the economic balance of power towards the emerging markets, especially China and India, suggests a new pattern in demand that can be difficult to predict. The increase in oil prices in 2004 might be overdone since there are some signs of a bubble developing in the market. But when this bubble, if it is there, will deflate is hard to gauge.
Conventional wisdom has it that allocation between asset classes is the most important determinant for success in portfolio management. In this low-yield environment I believe that allocation within asset classes is just as important or even more so. I estimate that global growth in 2005 will be modest and there will be a little upward pressure on inflation.
In this environment equities should moderately outperform bonds. But unforeseen increases in oil prices can quickly alter the picture. Instead of betting on future oil prices my approach is to be fairly neutral in the allocation to different asset classes. Within the asset classes, bonds and equities, there are a lot of opportunities to exploit in a portfolio.
Emerging market bonds and high-yield bonds still offer an attractive yield pickup compared with government bonds. I expect the credit quality to continue to improve in these markets. After the outcome of the US presidential election the dollar will be burdened by the double deficit in the US economy. Therefore the dollar will probably have to fall further to bring global trade and capital flows into better balance. So investment in the dollar denominated part of these bond markets should be hedged.
In the equity markets emerging markets are also favoured, with special focus on East Asia, eastern Europe and Russia. In the mature markets stable, visible growth is expected to be the winner. Therefore a defensive sector posture is recommended.
European equities seem to be relatively cheap and I consider it to be a very positive development that
European firms have finally succeeded in extracting wage concessions from the labour unions. This will pave the way for an advantageous development in unit labour costs and thereby a sounder cost structure and increased profitability in European companies.
Niels Skovvart is chief investment officer of Sydinvest in Aabenraa, Denmark

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