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Don’t bet on the roaring noughties |
At the beginning of any new year it is tempting to wipe the mould from the crystal ball and peer into what lies ahead for financial markets.
Such an exercise of course is fraught with danger and any economist worth his salt will have a number of possible scenarios from which an investor can choose.
Those in the employ of the private sector need to be more specific so have adopted the prudent practice of adjusting their long-term forecasts on a weekly, even daily basis. If you are going to forecast, forecast often.
The trouble with forecasting is that not only do we not know how everything interrelates but that we are dealing with human beings who stubbornly refuse to act consistently to the same set of economic conditions. In addition of course events like September 11 have a habit of popping up at unexpected times and causing chaos.
Nevertheless the temptation to make a few predictions is irresistible.
The latest pronouncement from the US Federal Reserve Chairman Alan Greenspan is that things are picking up in the United States. According to him the US economy has hit bottom and will start recovering sometime this year. If he is right it means that the worst is over, that interest rates are unlikely to fall much further and will probably start rising again. The risk of a share market collapse has receded.
Japan is still a basket case and it will probably take years to turn it around. Japan’s problems are not cyclical, they are structural – including a rapidly aging population, huge bad debt problems within the banking sector and a business / Government relationship that is too close to allow the necessary harsh reforms to be easily implemented. The world will just have to adjust to that.
Europe is looking soft but will probably recover as the US starts growing again.
In Australia we are a little ahead of the US in our economic cycle and our recovery is well underway. However in the first few months things will be a bit tough until the US engine kicks in and things get moving again.
So what does all this mean for financial markets?
The share market in both the US and Australia did reasonably well last year considering everything that happened and how it could have turned out.
If you add in dividends, the Australian market as a whole gave investors a 10 per cent return.
The best-performing sector of the Australian market was property trusts. This is not unusual when times are uncertain. The trusts are giving an income yield to investors of more than seven per cent on average. This not only cushions the returns to investors but provides a safe haven when things are turbulent elsewhere.
The return from overseas markets, excluding the effects of a weak Australian dollar was a negative 14 per cent on average.
But what of the future?
Barring an outbreak of the irrational exuberance that we saw in the high tech sector recently, returns from the share market are likely to be modest for the next year or so and possibly the rest of the noughties. The reason is that despite the economic slowdown in the US, share prices remain relatively high.
‘Normally’ when an economy looks as though it is headed for a recession, share prices drop sharply in expectation of lower profits. However this time round the US Standard and Poor 500 index for example has a price-earnings ratio, based on latest reported earnings, of around 40.
This is twice the average of the last 20 years and would have to be considered expensive, even if profits start to recover. Traditionally a P/E ratio of around 10 or 11 would be considered cheap, 15 to 20 fairly priced and above that expensive.
Arguably times are different this time round because inflation is low and interest rates are the lowest they have been for decades. In part this is because the monetary authorities have been so worried about the prospect of a major recession, they have being pumping money into the economy at an almost unprecedented rate. This has kept interest rates low and share prices high.
In fact official interest rates in the US are negative after adjusting for inflation. Over the next 12 months it is hard to see this changing very much. Interest rates are unlikely to go lower but are unlikely to rise by much either. Consequently a big fall in share prices is unlikely- but so too is a big rise.
In Australia things are much more on an even keel – mainly because we did not suffer from the high tech mania. The P/E ratio for the Australian market is around 19, which is probably reasonable value but not cheap.
If the interest rates scenario proves to be true then returns from the share market are likely to be modest over the next 12 months.
The same can probably be said for the property market. Prices are high in many places but if interest rates remain low then there should not be too many problems. But if inflation breaks out and interest rates start to rise rapidly, watch out.
The latest Australian inflation figures do show a big jump. This is probably just an aberration. But if not, beware, because the Reserve Bank and central banks around the world have taken more than 20 years to get inflation down to current levels and they are unlikely to let it ratchet higher.
Once inflation is entrenched it takes a great deal of pain to bring it down again. In other words in the absence of the unexpected, a steady as she goes year with returns lower than average.
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