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Some bold predictions and qualified advice for daring investors in 2004

By Peter Jonson - posted Tuesday, 13 January 2004


A year ago the prospect was for gradual global economic recovery. The US economy was showing signs of recovery and with China's ongoing boom this seemed likely to stimulate activity in Euroland and Japan. Except for Singapore, south-east Asia was growing again. Interest rates were low everywhere, with cash rates zero in Japan and only 1 per cent in the USA. The Bush administration had pushed serious fiscal stimulus into the US economy and most other countries were running stimulatory budget deficits.

The prospect was for gradual recovery; recovery that was likely to gather force as the year progressed. Inflation was no threat to recovery - indeed US Fed chief Alan Greenspan had warned that the threat of deflation was larger than the threat of inflation, and said that US interest rates would stay low for the foreseeable future.

Markets were expecting a better year. Commodities and equities were expected to rise gradually. Bond yields were low and not expected to rise until economic recovery was more firmly established. The US dollar was widely perceived as too high - with large and growing fiscal and current account deficits - and indeed the fall of the US dollar had begun.

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Wise forecasters must never ignore the X-factor. This is the unexpected shock that derails the smooth path usually predicted. In 2003, there was not one but two X-factors, and they were doozies. The first was SARS, whose apparently sudden emergence spooked people worldwide. It was winter, a major influenza pandemic had been predicted "sometime soon" by some medical experts and, above all, the authorities in China seemed not to be taking the situation seriously. Asian equities plummeted and there was a discernable check to confidence.

At the same time the long stand-off with Iraq seemed to be heading for action - most likely an invasion under UN auspices. In the event, the UN Security Council failed to support the hard-line position of the US and the UK. Unexpectedly for many, the US led "coalition of the willing" decided to act unilaterally, and went to war. While the X-factors were in play, fear and uncertainty provided a check to confidence and put the forecast gradual recovery at risk.

The war itself was over far more quickly than almost anyone expected. SARS also was fairly soon seen to be under control. Equities rallied, especially in Asia, and confidence was boosted. Despite the dreadful economic results in the June quarter (when confidence was at its lowest in most countries) the second half of the year saw economic momentum restored. Indeed, in the US the September quarter was one of the strongest on record. China, it emerged, had suffered very little damage from SARS, and the countries of south-east Asia, far harder hit by SARS, began to improve.

Reform finally delivered some dividend in Japan, and by year-end even the economies of Euroland were performing better. A rush of IPOs in the second half of the year, with sharply rising share prices generally, had boosted confidence in many countries.

Australia suffered one quarter of economic setback but generally sailed through the difficult period with considerable ease. Its cash rates were "below neutral", but at 4.75 per cent were high by international standards. Inflation is under control but credit growth and domestic demand have both been growing far too rapidly (with a related housing "bubble" and speculative excess) and toward year-end cash rates were raised by 50 basis points, with more rate rises expected in early 2004. The budget is in modest surplus but the current account deficit is too large. The Australian dollar has risen sharply, to be around US0.75 at year end.

New Zealand tells a similar story to that of Australia, although with domestic growth even faster and a currency rising even more strongly, presenting its monetary authorities with a similar but even sharper dilemma than that faced by the Australian central bank.

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My interpretation of 2003 is that the gradual global recovery expected at the beginning of the year was temporarily put on hold by the X-factors in the first half, and then bounced back stronger than expected in the second half. No automaticity here of course - the second half was probably always set to be stronger than predicted, and the rapid resolution of the threat from SARS and the imagined threat from Saddam's Weapons of Mass Destruction both boosted confidence above levels assumed by the forecasters at the start of the year.

Looking ahead to 2004, the best guess is a continuation of the strong recovery now clearly underway. Economic activity should everywhere be stronger than it has been for some time. The US may grow more slowly than in the second half of 2003 (which was clearly unsustainable) but other major regions should grow more quickly. China is the great unknown. Its economy has been growing at almost double-digit rates and there seems no good reason why this will not continue in 2004. India, too, is a potentially powerful economy that should also grow rapidly in 2004.

Inflation seems no great threat - indeed the US Fed still discusses the threat of deflation but one suspects with less than total enthusiasm. Other perceived risks concern the US fiscal and current account "imbalances." (An economic "imbalance" is the economist's attempt to allow for X-factors).

President Bush is determined not to repeat his father's mistake of winning a war and losing an election by ignoring the economy. He has pumped massive fiscal stimulus into the US economy, and the US budget deficit has been further boosted by military spending and the reconstruction of Iraq. So far at least, domestic and international financiers seem more than happy to finance the massive US budget deficit and US long bonds have risen by only 100 basis points from the very low yield of 3.10 per cent reached in early 2003.

The US current account has been blown out by US trade being uncompetitive. The rise of the US dollar and the strength of China's economy are the two main factors here. The long reduction in the value of the US dollar has further to run and will gradually help improve the US trade position. But if the US trade account fails to improve fast enough, loss of confidence by international investors could cause a flight from US-dollar assets with consequent instability in global financial markets. These markets are very resilient, but a perceived US trade crisis could have powerful adverse effects, especially if the US seemed determined to retreat from its current doctrine of relatively free trade.

House prices have risen sharply in several Western nations - over the past year by around 20 per cent in Australia, 25 per cent in the UK and about 10 per cent in the US. The Economist magazine during 2003 put a fair probability of a serious correction in house prices in these countries in the next few years - but such a correction seems unlikely to achieve the status of a serious X-factor in 2004, except possibly in Australia.

The most likely, as well as the potentially most serious X-factor in 2004 is the same as in 2003 - a major new terror attack, or series of terror attacks. It seems probable that action around the globe has reduced somewhat the capacity of the agents of mass terror. But it is also evident that their capacity has been great and is still far from negligible. But resolute overt action in Afghanistan and Iraq, and covert action in many other places have reduced the risks of a major terror event that could do major damage to the global economy, or to confidence in global economic recovery.

A senior mining man suggested to me that another possible X-Factor is that China might not be the economic hope all are assuming it to be and that it might actually implode. He wrote:

When everyone in the media seem to be waxing lyrically over China's stupendous economic growth, and the economic benefits it will bestow on our mineral industry, I just wonder, because the mob I do some work for dislike intensely doing business with them, from bitter experience ... Other than a Chinese economic collapse, how about the Indian subcontinent exploding after Mushareff is assassinated? Powder keg there.

Economic guru Alex Erskine suggests that the rise in productivity growth in the US is the real X-factor of 2003 and into 2004:

It is the only effective counter to China and India, and it will drive a further wedge between sleepy Europe and dynamic America. Which side will we co-habit with? Our productivity performance says 'Europe', but our trade negotiations and the commodity surge say 'USA'.

So what are the implication for investors in all this? Of course "it all depends" on investors individual wealth positions and appetite for risk. "Consult a Financial Planner", sacrifice a virgin and read Henry Thornton's Six rules for building wealth before getting too adventurous. If your financial planner, your spouse, your accountant and your physician have all cleared you for take-off, however, here is my advice.

"More of the same" seems to be the short-term message. The adventurous investor should be mostly long equities (especially the major resource companies), long commodities and short bonds and fixed interest. Equity and commodity markets surged late in 2003, and this is a bit of a worry. Waiting for a negative shock to provide better entry points seems unlikely to be the best strategy.

Choosing carefully which assets to buy (or sell) in which counries will provide a particular challenge. Asia will very likely be one of the strongest areas of the world in 2004 but, unfortunately, gaining access to some relevant markets is difficult for any but the most professional investors.

Picking the timing of the inevitable increase in global bond yields will remain vital and such a move seems far more likely in 2004 than it was in 2003. Once US bond yields begin to rise, investors should become especially wary of growth assets.

There will be money to be made as the Australian and New Zealand economies flirt with the possibility of serious setbacks caused by possible crises of confidence by international investors. If the Aussie dollar gets above US0.80 (as I expect), the chances of a crisis will rise exponentially. The Federal election in Australia may also provide a particularly juicy money-making opportunity for the bold investor.

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This article was first published on www.henrythornton.com. Click here to read the original.



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About the Author

Peter Jonson is a professional director and economist. He is a director of National Forum, Chair of the Federal Govenment's CRC Committee, Founding Chair of Australian Institute for Commercialisation (2002-2007), and Chair Emeritus of the Melbourne Institute Advisory Board. He is a Fellow of the Academy of the Social Sciences in Australia and a Fellow of the Australian Institute of Company Directors. Peter is founder and editor of Henrythornton.com, a virtual guide to economics, politics and investments.

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