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Time to be more discriminating

After having seen a resurgence of many negative shocks in the last three years, investors have rediscovered since mid-2003 two more positive factors. First, the strength of a global upturn driven by buoyant foreign trade, and second, the effectiveness of very accommodative economic policy (although this is at the cost of a return to public deficits). In 2004, what areas are likely to be the focus of investors attention and the main determinant for asset allocation?
As we all know, business climate indicators do not tend to go through the roof. However, judging by the most recent leading indicators, we might as well believe they could. Economic survey signals are very strong: corporate demand (inventory rebuilding and investment) everywhere is accelerating and household demand is bearing up well and even improving. As a result, growth should outstrip its potential in 2004 in the US (we expect GDP to expand by 5.0%), Japan (+1.9%), UK (+2.9%) and the Euro-zone (+2.0%). This return to growth will undoubtedly mean job creation (especially in the US), meaning that the growth should be shared and self-sustained. The economic scenario in 2004 is likely to result in the Fed and the ECB starting to raise their key rates during the year. Inflation will therefore be the factor that determines the exact timetable and extent of interest rate increases. In other word, inflation figures will be a particular focus of investor attention in 2004.
Volatility on the foreign exchange markets will be definitively a key factor. In the short term, the lack of economic policy coordination among countries may provoke over-reaction in the foreign exchanges rates. On this point, let’s be pragmatic. In the medium term however, we consider the risk to be asymmetrical and believe there is more likelihood of the dollar firming, notably because the dollar has depreciated by some 25% over the past 18 months and that should have a stabilising effect, by improving the US balance of payments situation. In addition, at the same time as US growth forecasts are being upgraded, tax revenue is also expected to increase, which will mean an immediate reduction in the budget deficit. All in all, the easing of tensions in both of the twin deficits – over the next 12 months at least –should mean less pressure on the dollar. Furthermore, uncertainty concerning the Fed’s monetary policy may diminish: the Fed may announce sooner than later that it is ready to increase its key rate. Given the interest-rate spread, the dollar could therefore strengthen.
In the short term, the bond markets – especially in the US – are being protected by the Fed, which has expressly acknowledged that it will patient before starting to tighten its monetary policy. However, in view of our scenario for growth, employment and inflation in the US, the Fed may signal a rate rise at any time. As a result, there is the prospect of an inversion of the Euro-zone/US bond spread in 2004, with inflation rising in the US. All in all, the bond markets are likely to deteriorate in 2004 as and when a cycle of interest-rate rises does actually get under way. In contrast, equities should improve if growth figures are confirmed. The pleasant surprises in economic terms also suggest an upgrading of earnings. There is likely to be an increase in capital operations (mergers, acquisitions, etc.) in 2004. Finally, there are signs of investors (pension funds, and others) wishing to boost their equities positions at the start this year.
As a result, in our asset allocation, we are still over-weighting the equity market but we are short on the bond allocation. Equity valuation today is fair in absolute terms, but if growth stays on there is no doubt in relative valuation: bonds are dear, and equities are cheap.
In this context, what are the risks? On the downside, the housing market is one of the main risk. Property prices have risen very sharply in countries such as the US, France, and there is may be an “irrational exuberance” in Australia, in the UK and Spain. The prospect of interest rate hikes in 2004 should reduce the demand for home loans throughout the world, thereby weighing on the housing market and household consumption. However, central banks have clearly identified this risk and this is one of the reasons why we expect only a gradual increase in interest rates.
On the upside, the biggest risk is a return to complacency on the equity marked, fuelled by flows. At present, financial analysts’ forecasts appear to be consistent with our macroeconomic scenario. However, we will have to keep watch to ensure that analysts do not go over the top when upgrading their forecasts, because this would reflect undue optimism.
Globally, the asset allocation in 2004 will be probably more fine-tuned than the last year as the cyclical gambles will be less and less obvious. In other words, the tracking error may be more concentrated inside each asset classes, with a more discriminating approach.
Christophe Morel is a strategist with CDC XIS AM in Paris

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