Looking ahead to 2005, our forecasts are that bond yields will rise modestly, taking the US 10-year Treasury to around 4.3% (compared to some 4.1% at the time of writing) and stay there till mid-year. Thereafter there is potential for yields weakening to sub-4% levels as growth in the US moderates.
For equities we see a significant risk of a marked fall of around 10% (compared to the levels at the time of writing, around 1200 on the S&P 500, 2750 on the DJ Stoxx 50).
In this environment, our initial recommendation is for investors to hold short dated or emerging market bonds and to reduce outright exposure to equities, instead holding products offering exposure to equity volatility, and those based on strategies that balance a long position in one part of the equity market against a short position elsewhere.
On currencies, we are still bearish on the dollar at its levels at the time of writing (106 yen, 1.29 euro). The re-peg of the Chinese renminbi to a basket of currencies, which we expect will take place by mid-2005, will trigger a general appreciation of Asian currencies against the US dollar by 3-5%.
However, this will not be sufficient to correct the imbalance in the US current account and we foresee further depreciation of the US dollar/Asia into late 2006 which will create further volatility in Asian currency markets. Excessive turbulence in currency markets in late 2005 could prompt a Plaza Accord-type arrangement emerging once more to create the conditions for an orderly appreciation of Asian currencies against the greenback.
The currencies most likely to appreciate with the renminbi at the time of a re-peg will be the Singapore dollar, Malaysian ringgit, Taiwanese dollar and Korean won. It will also be logical for the Hong Kong dollar to be simultaneously re-pegged at this time.
As we move towards mid-2005, higher bond yields and weaker equity markets should offer attractive entry opportunities. Specifically, we would look to buy bonds at around 4.3% for the US 10-year Treasury, or 3.9% for German Bunds, and to buy equities with the S&P at around 1000 or the DJ Stoxx 50 at 2300. At these levels, we believe that equities would offer reasonable medium-term value. We also view the bond yield levels referred to above as being well above the figures likely to prevail in the second half of 2005, when growth slows and a new deflationary scare emerges.
However, looking longer term to 2006 and beyond, we think bond yields could rise substantially above the 5% level, but that is an issue that can be addressed nearer the time.
Central to these investment recommendations is a paradox that we perceive in current asset prices. We estimate that the economic growth required to underpin current equity valuations, would probably generate more inflation than is implied by current bond yields. If this is correct, then there will be disappointment either for bond investors, or for equity investors, or both.
We think the most likely scenario is that over the next two or three months, growth is at least strong enough to support current equity prices. But if this is right, it would imply more inflationary pressure than is currently discounted by bond yields, and so those yields would have to rise. Interest rate increases by the Fed and other central banks would also be more aggressive than currently expected. After a time, bond investors would become reassured by this tough action, allowing yields to start declining, but equities would suffer. The result could be a sharp and decisive move downwards in equity prices, at some time in the first quarter, and a spike in volatility.
We have just entered a new stage of the global economic cycle, one that creates the conditions for this kind of instability. From early 2003 until late 2004, economic growth was accelerating, underpinning equity prices with the prospect of faster corporate earnings. As growth increased, it began to run well above the pace at which capacity was growing, so the amount of slack in the world economy was progressively reduced. From the Spring of 2004, this started to impact inflation, and the rally in equities stalled, but the downside impact was blunted by the fact that output growth was still accelerating.
Total return on US equities since 1853
But over the Autumn, we have reached a new stage in the cycle, potentially less benign. Global growth reached a peak (about 7% for world industrial production) and has started to slow. Compared to the first half of the year, this slowdown carries a greater risk that company earnings will disappoint. Yet because the slowdown is happening very gradually, the margin of spare capacity is still falling, intensifying inflationary pressure - even though the monthly data on this are, as usual, erratic. With less and less slack in the world economy, inflationary pressures will be worse in the fourth quarter than it was in the second, and worse again in early 2005. An adverse reaction in bond markets and in Fed policy, and from there into equities, seems the likely outcome.
These cyclical influences can also be placed in a longer-term context. The stock market bubble that reached its zenith at the start of 2000, took equities to a position of extreme over-valuation. It also pushed the real total return on equities far above the 7% trend line it has followed for 150 years (see chart above). The collapse that followed up to March 2003, and the subsequent partial recovery, means that at the time of writing, equities are close to fair value (based on consensus earnings expectations and on current bond yield levels). It also puts equity total returns back close to the trend line.
These observations do not give a sense of comfort. In the current environment of rising central bank rates, potentially higher bond yields, and gradually slowing growth, one would expect equity prices to stand below fair value. And following a period of excess such as that at the end of the 1990s, we would expect prices to fall back to well below trend, not merely close to it.
Following the previous four great bear markets in equity history, each lasting about three years (as this time), there was a partial recovery for about one year. After that, there was a period of four or five years when equities showed no medium-term direction either up or down, but did have substantial volatility at times, and only after that did they finally stage a convincing recovery. If the same pattern is followed this time, we are just entering that four to five year middle phase, during which equities offer value only if bought after significant down-moves.