What do you do after the ultimate high?

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For Stephan Gamper, a Swiss fund manager who helps manage $600m in stocks and bonds at Bank Sarasin & Cie in Basel, this year has been so good that it looks as though further profits will be scarce in 1998.

German bond yields, the pacesetters for Europe, are at record lows. Yields elsewhere in Europe are closer to German levels than they've ever been, and currency volatility in Europe has been all but killed off by the approach of the single currency. Global stock markets are at or near record highs. And economists seem convinced central banks have discovered the holy grail of keeping growth alive without rekindling inflation.

Moreover, emerging markets - the traditional hunting ground for investors forced to buy riskier securities than they would normally consider in an attempt to pump up their portfolio returns - have soured, felled by a dose of Asian flu.

All of which is going to make life difficult for money managers in the coming 12 months.

"The lower bond yields go, the higher the risk becomes in investing fresh money," says Mr Gamper. "And in stocks, excellent company earnings are already priced in. Even better than excellent is priced in."

Investors who made a lot of money in the major stock and bond markets this year - in a near-perfect economic environment - expect to find the going a lot tougher in 1998. They are banking on company earnings growth to propel benchmark stock indices to ever greater heights next year, and benign inflation to keep bond markets steady. Even that won't be enough to match this year's stellar performances in the major markets.

"The absolute returns won't be as attractive as in 1997," says Paul Abberley, head of fixed income at Lombard Odier Investment Management, which manages more than $8bn in stocks and bonds.

"Sooner or later, investors will have to become accustomed to less spectacular gains."

The benchmark Swiss stock index, for example, delivered a local currency total return including dividend reinvestment of almost 60 per cent this year. The British, French, Swedish, Italian, German and Dutch stock indices all posted returns of better than 25 per cent.

Bonds maturing in 10 years and more in those same markets also proved profitable, with local currency returns in double digits climbing to better than 20 per cent in the UK and topping 30 per cent in Italy.

"Given the record lows in bond yields, highs in stock prices and inflation becoming non-existent, it will be a lot tougher for the funds to make high returns in 1998," says Gavin Gilbert, at Bear Stearns International, who is switching from proprietary trading to a new group that markets trading strategies to investors.

With inflation stunned and bleeding, if not dead, in the world's major economies, however, investors aren't looking for bond yields to fall much more. At a four-year low of 5.92 per cent, the 30-year US Treasury, the bellwether for world bonds, is already within striking distance of the 5.75 per cent intraday record low it reached in October 1993.

"It will be increasingly difficult" to make money in bond markets next year, according to Adrian Owens, who helps manage $4.5bn of fixed-income securities at Julius Baer Investments. "Generally, I think there are few opportunities."

Mr Gamper says his preferred portfolio going into 1998 would be 50 per cent invested in equities, 40 per cent in bonds, and 10 per cent in cash - even though he expects the 20 to 25 per cent return on equities will be as much as seven times better than the alternatives.

"You cannot invest 100 per cent in equities because of the risk/return ratio," he says.

"You need the bonds for security, although the only money you'll make will be from the coupon payments. You won't make any capital gains unless you're very, very lucky."

The past few weeks, when slumping currencies and economies in Asia undermined global stock markets on fears that company earnings would be hit, driving investors into bonds, shows the importance of keeping money in bonds even when yields are low and prices aren't expected to rise, Mr Gamper says.

"A 6 per cent yield on 30-year Treasuries is very nice if you get a disaster in the stock market," he adds.

Mr Abberley at Lombard Odier says one way to enhance returns next year will be to make bigger bets on markets expected to be winners. "One key way will be to call the relative performance of the three blocs - US, Europe and Asia - taking, say, a 7 per cent exposure rather than 3 per cent."

Mr Abberley still sees some more juice in bonds, as more and more investors become convinced central banks have tackled inflation in the world's major economies, although he is recommending an overweight position in stocks, which will be the better performer.

With inflation not a problem, however, official rates will not rise, making cash, in his opinion, the worst investment.

"We expect both stocks and bonds to outperform cash," Mr Abberley says.

"There's still more possible momentum for bonds as people adjust their understanding of the new dynamic of inflation."

Copyright: IOS & Bloomberg