Stocks will perform better relative to bonds next year, for a third straight year, says Jeffrey Applegate, New York-based CIO at Fiduciary Trust, during a swing through the region.
"Two secular events define this business cycle," he says, "US labour productivity and the globalization of the labour supply."
Although America's labour productivity is slowing down, it has been very good for the past decade, and steady 2-3% rises will continue throughout the remainder of this business cycle. "This is positive for inflation," he says, "because most inflation in developed countries is due to the cost of labour." With productivity gains, core inflation won't pose a threat, and companies will be able to continue to grow earnings faster than sales. "This lengthens the business cycle."
The downside, however, is that labour force growth is weak, which is why the United States' economic recovery has not been marked by a similar rise in employment levels. But the reverse is true for emerging markets, where employment gains are robust.
The globalization of labour is also disinflationary. Wage conversion is inevitable when workers make $30 an hour in the US and $30 per month in developing countries. Combine this with productivity gains, and the economy gets a recurring, positive supply shock. "You get more for less," Applegate says.
As a result the global economy is enjoying its third year of business expansion, albeit with slightly lower growth rates. Fiduciary Trust estimates global GDP growth in 2005 will be a respectable 4.4%. The US and Japan will slow, with US GDP growth at 4.0% (down from 4.4% in 2004) and Japan falling from 4.1% to 3.0% - but these are still reasonable growth rates. Europe will remain anaemic with 2.2%. Most of the world's output gains will still come from China (forecast at 8.0%) and India (6.0%).
This growth is projected to coincide with mild inflation - around 2.2% in the developed world, and 6.3% in emerging markets. Oil prices are forecast to peak in 2005 and then climb down, although not to pre-2004 levels.
Low-cost labour should bode well for corporate earnings growth. "Labour is much more important than oil prices on company profits," Applegate notes. Fiduciary Trust estimates operating earnings per share for developed-country stocks will average 72.50 in 2005, up from an expected 55.41 in 2004.
Overall, decent but not spectacular growth and the benefits of cheap labour on earnings growth will allow stocks to outperform bonds. Stock markets are not going to shoot the lights out; gains will be modest. Moreover, the Federal Reserve isn't through with its fiscal tightening program.
The Fed has just bumped up short-term rates again, moving real interest rates from zero to positive territory. The real Fed funds rate is 0.5%, and the Fed has indicated it wants to eventually move to a real interest rate of around 2.0%, which means nominal rates of around 3.0% or more. The result is a flattening of the yield curve, as short-term rates move up faster than long-term ones. This means the yield on a 10-year Treasury bond will go up over the course of next year from 4% to 5%. It will be a tough year for portfolio managers to make money on bonds.
Applegate thinks the Fed is almost, but not quite done with its tightening policy. He is reducing his portfolio's short positions against the dollar because he thinks weakness against the euro is nearing a trough.
Over the next two years, the major currency trend will not be dollar vs. another currency, but the movement of a basket containing the dollar, the euro and the yen against Asian currencies, particularly the yuan.
That's because the US' economic relationship with China mirrors its long relationship with Japan. The old trade of "Toyotas for T-bills" is now replaced by US consumer demand for Chinese imports in return for China's financing the US deficits. Over time, Chinese and Indian wages will rise and their economies will develop. And just as the yen moved from Y400 to the dollar to Y100 to the dollar, so will Asian currencies adjust.
Applegate is not overly concerned about a dollar crisis. "As long as the US remains a dynamic local economy, the prospects are good that the dollar will remain the world's reserve currency. The twin deficits have been in the news for the past 30 years, and the dollar today now trades within 20% of the trade-weighted dollar over the past 20 years. The US remains the world's main engine of growth. The worst-case scenario is if the US slows down. Some critics think the Fed isn't raising rates enough - are you nuts?"
He says the problem in the global economy largely stems from the paucity of demand in Europe and Japan, but that China and India will come to replace this.
To take advantage of the modest prospects in the stock market, Fiduciary has moved to a sector-based approach. Applegate believes the rising correlations among global stock markets is not a cyclical event but a reflection of how the new, globalized world works. "Large-cap global business models are similar and accounting rules are harmonizing," he notes.
