China the new locomotive
In our last asset allocation comment for IPE in July 2003 we ended wondering when we will start to reduce our overweight equity position. Fortunately stock markets started a second leg up in autumn and we stayed long the whole year 2003. However, in January, after the EuroStoxx50 had risen 60% and the DAX 90% from their lows, we decided to go neutral again.
Meanwhile, we have even started to prolong the duration of our bond portfolios. We still are slightly short duration compared to the benchmark but will switch to neutral if Euro-zone 10 year bond yields rise above 4.5%.
For a balanced portfolio this means that we are coming back to recommend a more neutral position for the first time since spring 2003 when we had overweight equities and underweight bonds. The main reason for this re-positioning is that we feel that most of the good news for the global economy is already priced in considering a 10 months equity bull and 12 months bond bear market. Although analysts expect further improvements in company profits due to better economic conditions the stock market seems to be exhausted after the rally starting in spring 2003. Good profit figures are sometimes over-shadowed by cautious outlooks. Forecasts for 2005 and beyond are quite difficult as the geopolitical situation with the mess in Iraq and uncertainties with regard to the oil-price are major wild cards.
In addition to reducing disposable income of the consumers and therefore slowing demand on a global basis rising energy prices usually boost inflation figures. The trend of OECD/CPI figures and oil prices has been highly correlated over the last 20 years. If oil prices stay high or go even higher, inflation might become a problem for industrial countries again. Although monetary policy cannot fight rising oil prices by increasing interest rates, they might be forced to if energy prices strike through to higher costs and wages. In any case most economic forecasts for GDP growth in 2004 and 2005 assumed an oil price of $30 or less per barrel and not $40 or more.
In the short-term, however, global economic conditions continue to be positive as growth looks still healthy in the US, is strengthening further in Japan and is creeping up in the Eurozone. Therefore, we do not expect a major setback for equities and see no reason to go strongly underweight in this asset class. On the contrary, we expect the consolidation to continue with a good chance for a decent rally to come within the next weeks.
For the bond market, the situation seems a bit more cloudy for the short-term. On the one hand, a strong economy and rising inflation will force the Fed to increase short-term interest rates at least by 100 basis points over the next 12 months. On the other hand, Alan Greenspan has been preparing the market for this step for months. As a consequence, many market participants have been short duration for quite a while. As the yield curve has become dramatically steep the value of a bond portfolio is hurt if markets do not correct further. Yields for 10 year US bonds have risen from 3.6-4.6% within three months which means that a lot of future rate hikes have already been discounted by the market. For this reason we have started to reduce our underweight position in June and will go even longer as yields increase further. Nonetheless, our bond portfolios still show a duration slightly lower than the benchmark, so far.
We have seen asset bubbles throughout the last 10 years, from equities to bonds to housing and to credits, as Allan Greenspan reacted on every single crisis with adding a bit more liquidity to the system. The US is now the world’s largest net-debtor country and US-yields strongly depend on foreign purchases of bonds. As interest rates start rising the recent US recovery might stand on feet of clay as 2005 approaches.
The hope for the global recovery to go on beyond 2005/2006 lies in Asia and there foremost in China. Although China’s government is prepared to reduce growth rates this year the country has become a new locomotive for the world economy. China is big enough and growing fast enough to feed the global recovery even if the US upswing is fading. Together, with the eastern European countries on the move, Euro-zone equities should be supported on the longer-term as profits will rise further for the years to come.
Josef Kaesmeier is managing director of Merck Finck Invest in Munich