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More volatility ahead

As we move towards the end of the year, the outlook for markets remains relatively positive. Global growth is accelerating and developing a better balance among the major areas of the world. Inflation is low and unlikely to rise much. In some cases market valuations are discounting all the good news but in others there is still a favourable risk/reward trade-off and good technical support. Volatility has, however, once again increased and investors’ appetite for risk has been dulled by a combination of factors.
Firstly, there are the continuing aftershocks of the Asian financial crisis. The yield margin for emerging market debt has risen again in response to a variety of recent political and economic events in the developing world. Next, there is the big uncertainty over what will actually happen inside all the computer systems when the bells ring in the new millennium. This is causing companies to be particularly vigilant with respect to counterparty risk over the critical period and has caused a liquidity premium to appear in the credit markets. Companies of all kinds have started to build precautionary stockpiles of goods in case of some disruption to the supply chain at the start of next year. Consumers may follow their example, resulting in a further tightening in the credit markets and possibly some extra price pressure. Finally, after a period when global inflation has been trending down there is growing concern that we may be in for a period of rising inflation again. Certainly the Fed and the Bank of England are sufficiently concerned to have raised their key interest rates.
One of the consequences of the stockpiling that takes place ahead of the year-end is that there is likely to be some destocking in the new year. Both of these trends will distort the economic data that is so closely watched by investors. Whether the recovery in Asia is continuing to evolve or whether the US is moving into a soft landing will not be clear. Markets are likely to remain more volatile than normal during this period.
In this environment we are holding a very heavy position in UK equities. With the high proportion of foreign profits represented in the UK market, it should benefit from the better global growth outlook we expect. UK-based companies are following in the footsteps of their US cousins and putting more emphasis on shareholder value. This means relatively little new equity capital and in many cases a shrinking of the existing equity base. This is likely to continue to create a favourable supply/ demand situation for equity shares. The market valuation is fair in relation to the interest rate and inflation background and investors are likely to be increasing profit forecasts during the next year.
We also favour the Japanese and Latin American equity markets. There are signs that at last the Japanese economy is starting to shake off the after-effects of the 1980s boom and companies are beginning to address the low return on capital problem which has plagued them for a long time. The market has historically had a low correlation with the US market and this offers us some comfort at a time when we see significant risk in the US because of an extreme valuation and a deteriorating supply/demand situation. In the case of Latin American equities, valuations are low and we see scope for plenty positive surprises in reported profits in the coming months. In addition, we expect yield margins on their debt to fall as investors regain some appetite for risk over the next year and local interest rates should also fall further.
In our balanced funds we hold a heavy position in euro-denominated bonds. The yield has risen sharply in the past few months and the euro has been a weak currency. We expect the European economy to pick up but not to the degree that would cause the European Central Bank to raise interest rates in the short term. While the bond yield is unlikely to fall significantly, the combination of some capital gain and a stronger currency over the year ahead offers sterling-based investors the best opportunity within the bond markets.
We are holding a heavy cash position which we expect to reduce in the next few months as market volatility creates buying opportunities. Since we believe that the next few years will bring relatively good global economic growth we are more likely to be buying equities.
Ken Forman is with Standard Life Investments in Edinburgh

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