2003 Review and Outlook for 2004 -- Back to Normal, with A Few 21st Century Twists
When one looks at the numbers, it would appear that 2003 was an easy year for investors. Equity markets were up strongly, emerging market fixed income up almost 30%, gold up 20%, commodities such as oil and copper up around 45%, and developed market bonds up some 3%. <?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />
However, the fact is that 2003 was a tough year for investors due to a number of unusual risks that made implementing investment strategies more difficult than usual. Those risks included the threat of war with <?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />Iraq, terrorism, deflation, a dollar collapse and the unwinding of the equity bubble of the late 1990's.
The risks of war and deflation were especially troubling for investors as the downside of these could be large and uncertain. The main assault in Iraq is over, and Saddam suffered an ignominious defeat in an overwhelming display of US and Western military superiority. While the ongoing risk of occupying Iraq continues, and the threat of terrorism is ever-present, the unsettling potential of the hot war has ended.
The threat of deflation was even more distressing for some investors last year than that of war. Deflation, as seen in Japan , had the potential to liquidate significant amounts of wealth over a long period.
For now, the threat of deflation has receded. Gold, a leading inflation indicator, is above USD 400 per ounce. Commodity prices are up. Deflation in China has turned to inflation. Prices in Japan have bottomed.
Most importantly, the US economy has responded to major doses of both monetary and fiscal easing, aided by a drop in the dollar. At the beginning of 2003, many investors feared that the US was like Japan, and that the US economy would not respond to fiscal and monetary easing. With sizzling third quarter growth of 8.2%, the US economy was definitely responding. Deflation has been avoided, and a rapid increase in inflation is unlikely.
Whereas, war, deflation risks and a nasty bear market in equities made investing during 2003 difficult for investors, the diminution of those risks make investing during 2004 less problematic.
Therefore, we are back to "normal," but with a few 21st century twists. This means investors can re-focus on underlying big picture trends, which include: Technology, Globalization, Free Market Economics, Global Demographics and, The Development of China.
To some extent, investors have already refocused and discounted some of the information embedded in these trends, explaining some of the positive market results for 2003. However, for 2004, investors are going to become more intent on understanding and discounting what is new about the 21st century.
" Normal " in the twenty-first century includes confronting more profoundly the impact of the continuing march of technology. The tech crash caused people to take their eye off the technology ball. For several years, investors licked wounds from misplaced tech stock bets, and dismissed tech due to the over-exuberance and wild expectations for the internet.
The fact remains that technology is fundamentally changing many things, and that trend is accelerating, not decelerating. One compelling way that technology is changing life is in the area of work and jobs.
An economist at a large mutual fund company produced a report during the year that noted the US had lost manufacturing jobs from 1995 to 2002. The general presumption has been that those jobs had moved to China.
However, the study concluded that China had also lost manufacturing jobs during that same period. We verified this conclusion with well-placed Chinese authorities. This is a rather astounding bit of information. Something you really have to let sink in to appreciate all of the ramifications.
It is not just that the US is losing manufacturing jobs to a low cost producer, but that technology is making manufacturing more efficient, and factory jobs are disappearing all together. For example, the latest completely automated Intel chip plants do not require armies of highly paid technicians to support in the chip manufacturing process.
Further, the practice of outsourcing higher-level white collar and tech jobs is also becoming more prevalent due to the confluence of telecommunication improvements, the Internet, and globalization trends.
Job growth should pick up during 2004 given the amount of stimulus in the system already. But, job creation will become more of an issue during 2004 as the Fed is faced with an expanding economy, and job growth remaining below what is normally expected during an economic recovery. The debate will be further inflamed by political rhetoric during an election year.
Another twist of the twenty-first century includes the development of China, and to a lesser extent India and other emerging markets. This relates to the issue of jobs, but there are many more investment ramifications to the rapid development including the increased demand for commodities, currency levels, and the fight for global capital.
Investors in the early 21st century confront a widening US fiscal and trade deficits. 2004 will be a year that investors are forced to consider these imbalances more directly. 2003 proved to be kind a "free pass" year. The dollar declined, but not enough to trouble the US equity market, or force the Fed to raise rates to support the dollar. A weaker dollar will help US exporters compete overseas. 2004 may prove to be more troubling on this front for investors. Finally, radical Islam and the continued threat of terrorism are relatively new factors that investors must still consider. Other than these 21st century twists, we seem to be back to "normal."
Specifically, this means the following:
1. The US and global economy is responding to aggressive fiscal and monetary medicine
2. 2003 marks the end of aggressive central bank easing, and 2004 the beginning of central bank tightening
3. Range bound bond markets will ultimately sell off, and yield curves will flatten, though the sell-off will be moderate, unless the dollar really starts to collapse
4. The twin US deficits of fiscal and trade will trouble the dollar more until growth and higher rates finally reverse the downward trend
5. The China boom will continue despite the sceptics and some fiscal and monetary tightening there
6. Inflationary expectations will move up, along with further moves in commodities
7. Expensive equity markets will become more expensive.
The year 2004 will see a stronger global economy. The shifting cost of money in the global economy will present numerous investment opportunities in relative value and directional fixed income markets, as well as for global macro related trades.
By William Lawton, Chairman and Chief Investment Officer, Seagate Global Advisors.
Seagate manages the SeaMax Partners Fund, a USD 30 million global macro fixed income fund, up 43% net for 2003.
copyright hedgeweek 2004
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