Bird's eye view of global market woes

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The Independent Online
It is pause-for-thought time. The lull in financial market activity, with US Independence Day, meetings at the Fed and the Bundesbank this week and the Group of Seven summit at the weekend, has coincided with half- year investment strategy reviews of the various securities houses.

These will have been awkward documents to prepare, given that their clients will almost certainly have lost money on their investments during the past six months. Doing a little better than the index is small consolation if the index has plunged, particularly if the advisers were unwise enough to be bullish at the turn of the year.

The global outlooks of the securities houses are the best starting point. Though their grand sweep of the investment horizon - the Olympian demotion of Swiss bonds to underweight and promotion of Korean equities to aggressively overweight - can be off-putting, they give the best bird's eye view of the investment malaise sweeping all markets. Portfolio investment is increasingly a global game.

Take, for example, the work of Michael Hughes at BZW, which seeks to give a longer-term focus to its strategic advice. His latest strategy paper starts from the position that the investment environment is at its most confused since the global bear market of 1974, but that macro-economic conditions now are vastly different from then. He points out that since 1987 world equity markets and real bond yields have moved sideways. The rise of share prices during the past couple of years has merely brought prices back to their peaks of 1987 and 1989, while the violent swings in bond markets have left most of them close to their long-term average real yield.

Mr Hughes argues that the investment climate since 1987 has been characterised by two other features. Equity markets have been more volatile since then and the equity risk premium, the extra return people got from holding equities over bonds, has been falling.

He expects both now to reverse. The first would be the result of a sustained low-inflation environment - volatility should fall as investors come to expect dividends to make up a higher proportion of the return rather than rising capital values. The second will reverse as rising world growth increases earnings and these take over from interest rates as the main driving force for shares.

Conclusion? BZW remains positive about investment in financial assets. The rerating of markets brought about by lower inflationary expectations may be over, but real bond yields may fall, bringing a further rerating.

Much the same investment conclusion, but with a slightly different intellectual justification, comes from Peter Lyon at Smith New Court. He recalls that in January SNC said: 'We would advise investors to stand back from equities for the time being,' advice that looks canny now. SNC seems to regard it as axiomatic that investors should remain in the market and tries to identify long-term trends so that assets can be allocated most profitably.

Mr Lyon believes that investors should be overweight in Japan and very underweight in the US, where long bond yields should reach 8 per cent by the end of the year. He is positive about the UK despite the relatively poor performance of equities this year and even more positive about continental Europe.

Lehman Brothers is quite explicitly bullish in its International Economic Quarterly. It believes that the recent sell-off in bonds is irrational, for not only is inflation falling in Japan and continental Europe but fears of a capital shortage are misplaced.

It says: 'We expect global bond and equity markets to rally strongly by the new year . . . we simply do not believe in the recent trend of ever-rising growth and inflation expectations.' There has, it argues, been a shift in investors' preferences towards holding cash. This can be expected to reverse as growth decelerates and the Bundesbank and Bank of Japan cut interest rates.

Most other securities houses in London would echo this bullishness in a greater or lesser measure. Thus NatWest Markets feels that the fall in bond prices is overdone and inflation will remain subdued.

Morgan Grenfell also thinks yields have risen too far and inflationary fears are overdone, but is more sensitive to current nervousness, warning: 'A further marked decline in bond and equity markets is a distinct possibility.'

But in most cases the broad message is the same. We acknowledge the market's fears, but believe these are either unfounded or at least exaggerated. Maybe all the markets need is new information, be it from the Fed, the Bundesbank or G7, to recover their collective confidence.

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