Risks remain despite a relatively placid outlook for 2006

The consensus amongst economists is that the economic environment is looking particularly placid at the moment and that 2006 will be a year much like 2005. The US and Japanese economies are forecast to decelerate moderately, but this is expected to be offset by a modest acceleration in Europe. As a result, the advanced economies should again grow around 3 per cent over the next year, roughly their trend rate at which they can grow without overheating.

As they always do, forecasters expect oil prices to be almost the same – USD 56 – in a year’s time, which will mean that the recent energy-driven spike in inflation recedes. Moreover, with inflation settling down to an annual rate of just 2 per cent, policymakers should – if the forecasts are right – have little cause for concern. US and UK interest-rate setters will be able to take a break, European policymakers will be able to raise interest rates at a very leisurely pace, while the Bank of Japan can afford to be very patient.

In other words, 2006 will be a year devoid of surprises. However, policymakers themselves acknowledge that the economic outlook is especially hazy at the moment, partly because it appears so serene.

There are two main dangers to this economic nirvana. The first is that the jump in oil prices is not a spike, but simply part of a trend.

The International Monetary Fund expects the developing economies – led by India and China – to grow by more than 6 per cent this year, their fourth successive year of above-trend growth. Strong growth has meant that these countries’ demand for oil has been growing, on average 3.5 per cent a year, for the past five years. This is seven times the rate at which the developed economies’ demand for oil has grown. If rising demand continues to outpace supply, then oil prices will continue to edge higher.

At the moment, wage growth and underlying inflation – putting aside the direct impact of higher oil prices – remain relatively subdued. However, higher oil prices – unless merely a short-lived spike – eventually push up the price of transporting goods to the shops and getting to work, and this eventually feeds into higher wages and prices for other goods and services.

As a result, measures of inflation that exclude swings in energy prices tend to catch up with the headline measure, if energy prices continue to rise. Consequently, if oil prices continue their ascent, the inflation outlook will begin to look much less benign, forcing policymakers to raise interest rates over and above what the markets are currently forecasting. Oil is much less important than it used to be, but it still has the power to move economies and markets.

The other principal risk concerns the path of household saving and borrowing. In recent years, the key distinction between the economies that have lagged and those that have prospered has been the trends in household saving. Households in the UK and US have been content to save less of their income and borrow more, buoyed by rising stock markets and house prices. In contrast, Japanese and European households have raised their savings in response to rising unemployment and in some cases – especially Japan — falling property prices.

With property and jobs markets strengthening, Japanese and European households may feel encouraged to save less of their incomes and borrow more, boosting growth. At the same time, with house prices at the very least stretched in the UK and US, there is the risk that a weaker housing market persuades profligate households to curtail their borrowing and save more.

Together, these risks could mean that global growth proves weaker or stronger than expected, dampening or stoking inflation respectively, or that cost pressures begin to push inflation and interest rates higher. The current, tranquil economic climate means that stock market valuations continue to remain supported by reasonable profit growth and that equities still look better value than bonds, but 2006 may yet have some surprises in store.

Stable outlook means US dollar rally should continue

The economic climate has been so stable all year that economists’ current forecasts of growth during 2005 and 2006 are the same as they were a year earlier. Activity is expected to soften very marginally over the next 12 months, but for all intents and purposes the US economic climate is expected to remain unchanged, with growth at, or very close to, the economy’s 3.5 per cent long-term trend rate.

The lack of any real surprises helps to explain Wall Street’s directionless nature, with US equities climbing only 5 per cent compared to the 40 per cent and 20 per cent returns enjoyed by Japanese and European bourses.  Nevertheless, the monetary environment remains supportive, despite the rise in interest rates orchestrated by the Federal Reserve, and weaker oil prices should also lift growth.

Moreover, recently most economic indicators have surpassed forecasts, suggesting that both the economy and Wall Street should get the New Year off to a good start.

Whereas the US stock market has struggled, the US dollar has shone. The dollar’s fortunes first improved when the Federal Reserve raised interest rates above those in the euro zone at the end of 2004. Although the money markets increasingly believe the Federal Reserve will leave policy unchanged after current Chairman Alan Greenspan retires at the end of January, interest rates will remain at a level sufficient to attract foreign capital and to support the US dollar. Moreover, inflation is expected to abate, helping to alleviate any fears investors might have that inflation is growing out of control. Consequently, the US dollar’s rally is set to persist for the time being.

The lack of any real inflationary pressures is also good news for the US bond market. However, US equities still look better value at current yields and the 4.45 per cent 10-year yield offers only a modest premium over short-term interest rates. While such a negligible premium would be warranted if the Federal Reserve were on the brink of cutting interest rates, for the moment government bond markets elsewhere remain better value.

Sentiment towards Japan stronger than the underlying economic climate

At the beginning of 2005, Japan was still in recession and the stock market was languishing. However, spring ushered in a reversal in the market’s fortunes. Since then, sentiment towards both the Japanese economy and stock market has snowballed. Consumer spending has been its strongest in more than a decade, buoyed by a more upbeat jobs market, provoking speculation that Japan was embarking on a self-sustained recovery. Prime Minister Koizumi’s landslide victory in September’s snap election – called after his loss of a key Upper House vote on Post Office reform – further bolstered sentiment and raised hopes that the country would accelerate the pace of restructuring. The surge in foreign buying since the middle of the year has helped to propel stocks almost 40 per cent higher, making the Japanese market the best-performing major market in 2005.

However, while foreign investors’ optimism towards Japan has soared, the underlying economic climate has softened. Consumer spending has cooled since it surged in the spring, exports have been shrinking for most of the year and industrial production has stagnated. With manufacturers accounting for more than half of the Japanese market, it is not surprising that corporate profits closely follow swings in industrial production.

As a result, the downturn in industrial production means that profit growth has been decelerating all year. Moreover, the profit-related bonuses that workers receive every winter and summer mean that real wages follow swings in profits, compounding the impact. Sentiment towards the Japanese market, therefore, has proved more upbeat than the underlying economic environment.

Nevertheless, the economic climate is beginning to improve again; an upturn in electronics orders means that exports are growing once more and that industrial production is recovering. With sentiment still very upbeat and the economic climate strengthening, Japanese equities should continue to outperform markets elsewhere.

The prospects for the Japanese yen look less positive. Although the economic climate is improving, the Bank of Japan is unlikely to raise interest rates until the second half of 2006 and even then only modestly. As a result, the low level of Japanese interest rates will continue to be a burden on the currency, as will the persistent ascent in the prices of commodities, most of which Japan has to import. The yen has fallen more than 10 per cent against the US dollar over the past year and for the moment the currency looks set to remain out of favour, and its recent reversal to prove short-lived.

European profit surge propels equity markets higher

It has been a good year for European firms, despite the lacklustre economic backdrop. Profits in Europe (excluding the UK) surged 40 per cent in 2005, bettering the 30 per cent growth they managed the year before. The explanation for the jump in profitability has been the ability of firms to cut costs, using increased productivity to keep down the size of their workforces and boost profits, rather than to raise wages. The downside has been that firms’ reluctance to take on more workers or raise wages has been the reason why consumer spending has remained so depressed. Firms are now starting to hire again, unemployment is falling and profit growth is beginning to cool from its breakneck pace.  However, the pick up in the economic climate should give profits a second wind and help to keep European markets buoyant.

Nevertheless, although Europe’s economic climate is looking brighter all the time, the recovery is still in its early stages and remains vulnerable. In particular, there is a risk that European policymakers get a little carried away and repeat the mistakes that their Japanese counterparts made in the 1990s – raise interest rates too far too prematurely and hike taxes in an attempt to rein in the ballooning budget deficit.

Germany’s new Chancellor, Angela Merkel, plans to raise sales taxes in 2007, which perversely could boost spending in 2006 as consumers try to beat the tax. In addition, the European Central Bank has expressed concern at the pace at which bank lending is growing and the danger that underlying inflation begins to catch up with the acceleration in headline inflation induced by higher oil prices. For the moment, though, the economic environment remains fairly promising and European equity markets have every reason to begin 2006 on a strong note.

European bond markets still look out of line with government bond markets elsewhere, particularly given that the money market is expecting the gap between European short-term interest rates and those elsewhere to narrow sharply over the next year. However, while the interest-rate outlook means that European bond markets are likely to lag markets elsewhere, it should at least help to prop up the euro, which has depreciated 12 per cent against the US dollar over the past year.

Euro zone interest rates will remain low by international standards, but the turn in the euro zone interest-rate cycle should help to boost investors’ appetite for the currency. Nevertheless, unless European policymakers raise interest rates more aggressively than expected by the markets, the euro is likely to remain under pressure.

UK profits fail to match economic outperformance

The UK economy has outpaced the euro zone for 11 of the past 13 years, growing on average 0.75 per cent a year more quickly. However, although economists still expect the country to outshine the euro zone in 2006, the UK’s economic superiority may be coming to an end. Much rests on whether the recent pick up in the housing market can be sustained. The fact that house prices stand at more than 5 1/2 times borrowers’ income and consumer borrowing – including borrowing on mortgages and credit cards – is 130 per cent of household income, suggests the UK is unlikely to match the growth rates it has managed over the past decade or so. Moreover, unemployment – at 4.6 per cent – is the second lowest in Europe after Ireland, so that there is little scope for falling joblessness to boost growth.

Therefore, although both the housing market and consumer spending may be reaccelerating, there is little chance of a re-run of the 1990s consumer boom. More restrained consumer spending may eventually allow the Bank of England to cut interest rates again, particularly given inflation remains very benign. However, an early move would risk rekindling the consumer boom that the Bank has fought successfully to bring under control.

For the time being, therefore, interest rates are likely to remain unchanged, with the distant prospect of a cut sometime in the future when the current upturn in household spending wanes. This ought to be sufficient to just about prop up the pound. With central banks elsewhere still raising interest rates and in some cases just embarking on a path of tightening policy, and UK 10-year yields still fairly high by international standards, UK government bonds look set to outperform markets elsewhere.

Although the UK has enjoyed more than a decade of stronger economic growth than the rest of Europe, profit growth has been fairly sluggish in comparison. Over the past decade, earnings per share in France and Germany have grown twice as quickly as in the UK. Only the rise in the oil price has allowed UK profits to keep up with earnings in Europe during recent years. Therefore, the recent fall in the oil price continues to be a drag on the UK market and investment analysts remain relatively downbeat on the profit outlook. Foreign investors also continue to shun the market and the relatively high level of UK interest rates is another obstacle.

Consequently, without a boost from higher oil prices, UK equities will find it difficult to keep up with markets elsewhere and may even struggle to match the gilt market.

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