If the performance of financial assets in the first quarter of 1998 is anything to go by, Goldilocks is alive and well and clearly living in the mature western economies. This scenario of solid economic growth, low inflation, loose monetary policy and a tight fiscal stance has been particularly favourable for bonds and equities over the past few years and in Europe convergence plays and the benefits of EMU add to this heady cocktail.
In the US long bond yields have gone back through 6% as the Federal Reserve has indicated that they are moving towards a tightening bias given the strength of the latest economic data and the limited effect that the Asian crisis has had so far on growth rates. However looking through the next six months towards the end of the year and into 1999 we believe the US economy will cool down, as high real interest rates, slowing earnings growth and a lagged effect from Asia all conspire together. Given this background bond investors may well conclude that they have seen the peak of this economic cycle and push bond yields lower whilst equity investors on the other hand may conclude high valuations and relative low single-digit earnings growth do not go hand in hand.
In Europe the circumstances are reversed as economic growth continues to pick up in the core" economies and the strong growth seen in the peripheral markets continues unabated as the convergence of interest rates continues with the introduction of the euro. Given high levels of unemployment and a certain amount of spare capacity in the European economies the central bank may let this environment continue for a while but at some point rates will have to rise. Corporate earnings are likely to be very strong given this background and will be further supported by corporate restructuring and improving productivity.
In Asia the Japanese economy seems destined to continue its slow deflationary spiral as neither government expenditure nor tax cuts seem able to boost domestic demand to a meaningful extent. Government attempts to restructure the economy will yield some benefits but again the effects will be limited to certain sectors. Elsewhere in the region China, and by association Hong Kong, offer some attractions. But further currency weakness seems likely in Korea and Malaysia and, given the collapse in inter-regional trade, the ability of economies to export their way out of difficulty seems limited.
Overall the outlook is a little less attractive than in the recent past as Goldilocks begins to age, albeit gracefully. Returns for both bonds and equities are likely to be modestly positive with bonds slightly outperforming on a 12-month view. Within each asset class we favour US bonds and European equities with a neutral bet on currencies.
Mark Phelps is head of global equities for Dresdner RCM in London"