5 January 2004
The start of a new year is usually the time when two things happen: People make resolutions for the new year and analysts make forecasts for financial markets. After an eventful year in 2003, there has been no shortage of forecasts for 2004.
With regards to events, financial markets in 2003 were largely dominated by two major ones that occurred in the first half of the year: the Iraq war and SARS (severe acute respiratory syndrome). The prelude to the Iraq war caused stock prices to fall and gold and oil prices to rise. Even before the war ended, the spread of SARS around the world exacerbated the gloom on stocks.
And yet, it was around the period of the Iraq war and SARS that equities worldwide made their bottoms. Equities have since rallied handsomely, with big gains especially seen in small-caps and emerging markets as economies around the world recovered.
Prices of commodities also rose in 2003, with the rise in gold prices in particular capturing the public imagination. One reason for the rise in commodity prices is the rise in demand from China, as that nation's economy flexed its manufacturing muscle. As a result, oil prices failed to fall after the end of the Iraq war.
However, another perspective on the rise in commodity prices is that they simply reflect the fall in the US dollar in which they are denominated. Or put in another way, the growth in money supply in the US resulting from the Federal Reserve's attempt to reflate the US economy caused commodity price inflation, particularly since many other countries, especially in Asia, tried to keep their currencies pegged to the US dollar and kept monetary policy loose as well.
And that brings us to the other dominating theme in 2003: The decline of the exchange rate for the US dollar. Long considered overvalued by some analysts, last year finally saw this opinion become a consensus. No doubt, a large part of this recognition came about as a result of persistent job losses in the US, which in turn led to the long-overdue realisation that the US has out-priced itself in many economic sectors relative to emerging markets like China and India. The flip side of a weaker dollar is a stronger euro and yen, especially the former, which hit all-time record highs against the US currency.
So what is in store for investors in 2004? According to most analysts, probably more of the same.
As the world economy continues to recover, commodity prices are likely to continue their uptrends. Interest rates will probably follow. In this regard, my opinion is that long-term bond yields are likely to trend upward regardless of whether the Federal Reserve tightens on the short end as investors brace for more inflation and foreign investors become more wary of the US currency and reduce purchases of US dollar-denominated bonds. That, of course, also means that the US currency will stay weak. However, while the US dollar weakened mostly against the euro in 2003, for this year, many analysts predict that the fall is likely to be mainly against Asian currencies, which actually account for the bulk of the US current account deficit.
The outlook for equities is a little less clear. Stock prices are leading indicators, so they can be used to predict other economic and financial variables but are themselves more difficult to predict. One favourite way of mine to predict the stock market direction is to look at market valuation in relation to the current phase in the economic cycle.
The US market is currently probably trading at a forward price-earnings ratio of about 18. While above its long-term average, it is well below its recent average. Furthermore, with the economic recovery just beginning, investors are likely to anticipate further earnings growth and be willing to pay a premium. Therefore, there is potential for prices of US equities to rise.
Asian equities are expected to do even better. Historically, these markets have outperformed when global economic growth is strong because they are more geared to the economic cycle, that is, corporate profits rise more from stronger demand than in the US and Europe. And most Asian markets are still relatively cheap compared to the US; Singapore, for example, trades at below 16 times 2004 earnings.
The main concern for equities is the sustainability of the ongoing economic recovery. The recovery has been largely fuelled by loose monetary policy and US federal tax cuts. Once the effects of these measures dissipate, the combination of interest rate increases with huge budget deficits and corporate and household debts is likely to cause the US economy to slow, probably in the second half of 2004. As a result, many forecasters are predicting stock markets to achieve most of their gains for the year in the first half. The question is whether markets merely slow down, flatten or fall thereafter.
But there are worse possibilities. What if the bullish consensus for the early part of the year proves to be a contrarian signal? Or if equities fulfill their role as leading indicators by commencing a decline early in 2004 in anticipation of a second half slow-down? Despite the confidence of many economists in the strength of the recovery, there are still many uncertainties in the economy.
Of course, economic and financial forecasting has never been easy. Last year was one of those where analysts largely got it right; except for a few like JP Morgan's Carlos Asilis and Merrill Lynch's Richard Bernstein, most had expected the US market to end in positive territory. However, two years ago, Barron's had reported that 9 out of 10 analysts predicted that US stocks would rise in 2002; stocks went on to fall 23 percent. And of course, the granddaddy of forecasting mistakes occurred during the late 1990s' stock market bubble itself, when some analysts were forecasting Dow 30,000 and even 40,000.
Perhaps investors and analysts alike would be better off spending the new year making personal resolutions rather than financial forecasts. The chances of success may be higher.
Disclaimer: The commentaries posted here represent the opinions of the author at the time of posting and should not be taken as investment advice. Readers who wish to take any investment action based on information obtained from this site should seek appropriate advice from a qualified financial adviser.