You accurately forecast that global equities would outperform global bonds last year, and you say it will happen again in 2008. Why is that?
Applegate: A key reason is globalisation of labour supply, so even though in recent years we have seen strong commodity and energy prices, there has been low core inflation. To us, a key reason û in fact, probably the reason û that global equities have done so well in this century is that core inflation has remained largely range bound around 2% to 3%. In addition to the globalisation of the labour supply, good US labour-productivity growth has helped this story.
Persistently low inflation has been the secular event of the equity bull cycle û and itÆs a main reason why we think global equities will have another positive year in 2008, as absurd as that sounds at the moment while the markets are down.
Globalisation of the labour supply isnÆt going away anytime soon, so the positive effect on inflation isnÆt going away anytime soon. And historically, low inflation coincides with above-average equity returns. Since core inflation peaked and the secular bull market in equities began in 1982, the average annual return from US equities has been 18% -- far exceeding normalised long-term equity returns. By contrast, during the secular bear market in US equities from 1968 to 1982, equity returns averaged 6%, while real returns û thanks to high inflation û were -2%.
So there is a corollary between inflation and equity performance. ThatÆs why I hold the view that prospects bode well for a long business and profit cycle û and see global equities as outperforming global bonds this year.
So what are some of the strong investment themes you see for this year?
Sze: Look to funds that invest in agricultural commodities because this is a lagging asset class. Emerging market industrialisation and accelerating emerging market inflation (inflation, as you know, is rising in places like China) is combining with tight inventories and eroding global planting and harvest area to create upward pressure on agricultural commodity prices. Industrial metals (such as steel and copper), energy (such as oil and gas) and to a lesser extent, precious metals have already begun to price in this new environment. However, agricultural commodities have lagged other commodities, creating an opportunity for investors in 2008.
Aside from agricultural, what else is a good bet?
Sze: Earnings growth forecast for emerging markets are still substantial although they are expected to drop from 31 percent in 2007 to 21 percent in 2008. Emerging market economic conditions continue to improve. Rising emerging market inflation combined with strong real growth creates the prospect for strong nominal earnings growth.
Attractive valuations combine with excess global liquidity present opportunities in regions such as Latin America and the Middle East. A weak US dollar, strong regional currencies and robust commodity prices, for example, should support equities in Latin America.
What about distressed assets?
Sze: Distressed strategies perform well during high volatility, wide and widening credit spread environments. Historically, a pick-up and a peak in lower-quality issuance as a percentage of total new issues in the US credit market, as seen from 2004-2007, has preceded an acceleration in credit default rates. Although it is still early to enter the market, investors should bear in mind that picking assets at their absolute bottom is impossible. Investors can take advantage of the opportunities created by the credit dislocation when prices in certain sectors are depressed by forced selling, and subsequently realizing on the investments after the sector has recovered.
And the equity story versus the bond story?
Applegate: Much depends upon how central bankers behave. Any global central-bank easing should be more positive for equities than bonds. Within the global equity market, the underperforming financials sector should be among the primary leaders in a market rally. Despite the recent spate of bad news, sector fundamentals remain healthy. Profits would need to come under more pressure than is likely before sector-level dividends are cut. Finally, valuations are modest.
So weÆre out of the woods?
Applegate: WeÆre not suggesting that all the credit losses have been aired, but the sector is discounting a global recession that we do not think will occur. Emerging-market equities should also benefit from easier global monetary policy. These stocks are outperforming global equitiesùthanks in part to low-to-negative interest rates in much of developing Asiaùand we think this momentum could continue. Profit growth also remains strong, while valuations are not particularly rich. Thus, while we may not be out of the woods yet, we donÆt think recent credit-market tightening will push the global economy into recession. Key central banks will act to avoid it, in our opinion. While global financial markets wonÆt unfold in a straight line, we expect global equity prices will climb higher in the months and quarters ahead.
Some peoples' criticism of core inflation is that it knocks out energy costs -- and nowadays, given that energy prices are so high -- core inflations may not accurately represent the inflation impact on the average person. If that's the case, might the historical connection between low core inflation and good stock returns be challenged?
Crude oil prices have gone from $10 to $90 alongside robust equity returns. Core not headline inflation is a critical variable behind this.
¬ Haymarket Media Limited. All rights reserved.
