The flattening of the global yield curve suggests that economic growth could weaken significantly which is in large part a consequence of the Asian crisis. We expect the pace of economic activity in the US to slow down in 1998. A strong dollar and weaker global demand will dampen net exports. This is partly offset by strong private consumption. In Eur-ope, we expect the economic recovery to continue with the focus shifting from export to domestic growth. In Japan, the Asian turbulence will substantially reduce GDP growth.
Global inflation will come down further. In the US, soft inflation readings reflects very weak goods prices offsetting modest service price inflation. The sharp slowdown in economic activity in Asia reduces the likelihood that central banks will tighten. There is a high possibility that the next step by the Fed could be to cut the funds rate in the second half of 1998. In Japan we do not expect any change in monetary policy. Our bond markets forecasts are optimistic for the US and Europe. The trend for bond yields will be downwards in the US and to a lesser degree in Europe.
The Asian crises have several negative implications on corporate earnings that might not yet have been fully discounted. Global equity valuation ex Japan is close to long term historical average when using bond yields and 1998 earnings forecasts. This implies that levels of returns are not sustainable over a longer period. Near term profit margins will continue to benefit from lower prices of raw material and oil as well as from lower interest rates. Running our rather optimistic forecast on bond yields and normalised earnings through the model, equity markets seems to be near fair value. We are therefore keeping a neutral position between bonds and equities.
We overweight Europe within our equity allocation. This is supported by relatively optimistic forecasts on bond yields, monetary policy and earnings compared to consensus. We are adopting small underweights for the US, Japan and the rest of Asia. We are concerned about the more long term outlook for Japanese equities and the rest of Asia. Short term internal political pressures could lead to a new package of fiscal stimulation with a positive impact on equities. Prospects for the rest of Asian economies are weak. We feel that this already is a broad consensus view and clearly there is a risk of being too underweighted.
Overall we see three main risks to our global equity scenario:
q Further economic turbulence in China and Hong Kong;
q Deepening credit crunch in Japan; q Deteriorating global pricing power.
At WASA, the investment philosophy builds on the assumption that financial market prices are driven by changes in market expectations. The approach to tactical asset allocation is to identify not yet discounted charges in macro - and microeconomic factors. Forecasts are systematically compared with consensus in order to estimate returns in separate asset classes. Valuation using normalised earnings is used as a complementary indicator in our model. The final tactical asset mix is implemented by futures overlay.
Per Lundborg is head of asset allocation at WASA Asset Management in Stockholm