The world seen from Montreal

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The Independent Online
Every year the Bank Credit Analyst, a specialist financial magazine and research group in Montreal, takes a look forward at the next 12 months in the form of a conversation with a long- time subscriber to its service. This deserves a wider audience, not just because it is always an interesting exercise in its own right - the BCA people are among the most cerebral observers of the world economy - but also because it provides a useful backdrop, a benchmark against which people can test their own ideas of the future.

This year the big picture is one of continuing adjustment to the excesses of the 1980s, of continued US economic growth but very weak growth in continental Europe and Japan, a firm dollar but volatile equity markets.

The intellectual starting point for BCA is that though there are structural weaknesses in the US, particularly its low overall savings rate, which damage its low-term growth potential there are signs that the 'sounder' financial and industrial policies of countries such as Germany and Japan are beginning to break down.

The result is that while the US very much needs to correct these structural weaknesses, in particular by cutting both private and public sector consumption, Germany and Japan need to deal with rather different weaknesses - they need to deregulate their economies and to stop excessively deflationary policies.

In any case, the US economy is ahead of Japan and continental Europe in the economy cycle and so will continue to show decent - a little above 3 per cent - economic growth for another year. Recovery will start in Japan this year, but will be very muted in Germany. This poor performance of Europe's largest economy will pull down growth throughout the European economic area. The fastest-growing economy will be the UK, but we will grow at only 2 per cent, which would be at the bottom end of most forecasters' range.

Among the other large economies, China will have an inflationary surge followed by a hard landing later in the year. (An interesting shift here, that investment analysts now include China in their forecasts as a matter of course. It would have been unthinkable even five years ago.)

Translating an economic outlook into financial market movements is always a most uncertain business, but the general thrust of the BCA analysis would suggest that markets have run too far ahead of themselves. There are substantial dangers for investors.

In the US, short-term interest rates will start to nudge upwards, rising by one percentage point to 4 per cent by year-end. There is a danger that long-term rates will also rise, and US equities are likely to fall by about 15 per cent, probably in the first half of the year, before resuming an uptrend.

Other markets? The BCA team believes that the Japanese market will recover somewhat and that continental European equity markets will rise another 10 to 15 per cent this year.

British share prices can also sustain a further rise. Though the bull market is very mature, the potential for a correction or a bear market will only really start to grow after these further rises.

Of the other markets, Hong Kong is vulnerable in the short term, but should rise further in the long, while favoured emerging markets are Korea, Taiwan and Mexico. Finally, among world currencies, the dollar will remain strong, reflecting the advanced stage of the US economic cycle.

That, then, is the view from Montreal. How might other people test their own views against it?

There would be a wide degree of acceptance of the fundamental analysis here, in particular of the cyclical positions of the US, continental Europe and Japan. There might be some debate whether the BCA people were being too optimistic about Japanese economic prospects, for it is not at all clear that recovery will be in place by the end of this year.

And people here might expect rather higher growth - the 2 per cent figure would be much at the bottom of the expected range. But most would agree with the not-at- all optimistic picture for continental Europe.

Where there is greater room for dissent would be over the implications for financial markets. Most would accept that on rational valuation there is little room for US securities to perform much better over the next year. But the proposition that shares are rather overvalued, yet are worth holding despite the risks because they may become even more overvalued in the next few months, is very uncomfortable. It acknowledges that not only are Wall Street valuations unstable, but so are the main European markets and Hong Kong.

Of course, in a sense share prices are always unstable - it is their nature to be so. But the BCA discussion focuses attention on why they should be particularly unstable at the moment.

People are buying stocks and bonds because the central banks have created a lot of liquidity and there has been very modest growth to mop this up. They are, in the words of the BCA team, 'the only ganmes in town'.

''How long,' asks Mr X, the long-time subscriber, 'could these bubble conditions last?'

'Probably for quite a while,' replies BCA, 'because we do not see an early end to the current environment of moderate economic growth, subdued inflation and low interest rates.'

And that, surely, is the nub of the investment dilemma at the moment. If there were any sign of a return of inflation, naturally that would push up interest rates and kill the financial market boom. But that is most unlikely, certainly in the next 12 months.

If there were any sign of more serious global deflation present share prices would become clearly overvalued too. But again there is little likelihood of that in the next year. So, in the absence of either, markets have to live with the proposition that though share prices are very high they may remain high for some time.

But, even if one accepts all this, there is a possibility that investors will suddenly become frightened and feel that they should lock into their present gains.

Even a change of mood might provoke the long-awaited 'adjustment', broker-speak for the next share price crash.

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