North America

  • After some profit taking and jitters about the economic and political outlook that weighed on the indices last week, it looks like buyers are willing to dip their toes in the stock market again. The presence of hedge funds, as well as institutional participation, means that we should continue to experience volatility in the market. It is still an open question how broad an involvement we will see from retail investors, who have been essentially marginalised during the past couple of months. The data on mutual fund flows aren’t too encouraging, regarding individuals’ confidence in a sustainable upward trend for equities. Basically, they are uncomfortable with the seesaw movements and will only take part when they see some measure of consistency and stability.
  • There is a bit of unease in some quarters whether technology stocks, which have had a very good run-up since the lows in October, can sustain the rally into the first quarter. Valuations are quite rich and many stocks are priced on the basis of fairly optimistic forward earnings expectations. So unless the initial outturn of events provides confirmation of current views, the sector may suffer a bit of stumbling.
  • Geopolitical uncertainties remain high and the consensus expectation is that extensive military action in Iraq is highly likely in late January or early February. Meanwhile, a number of other political events, from North Korean bluffing to reports of Al-Qaeda attack preparations, have combined to rattle investor confidence. The base-case scenario regarding military conflict in Iraq remains one of quick victory for American forces. Preventing Iraq from disintegrating will be a more difficult problem. Normally, when a narrowly-based dictatorship collapses there is a power vacuum, and it is not yet clear how the Bush administration will act to fill the void created by the departure of Saddam Hussein.
  • The political opposition in Iraq is fragmented and weak, with little experience of running a country. One solution would be to back a military strongman. But that carries the risk of an uprising by one of the major ethnic power groups. There are indications that the Americans are considering the idea of administering the country until viable political institutions are built up. This will be challenging, but may provide major advantages in the form of ideology and demonstration effect for other countries in the region. So, in sum, the short-term consequence of the coming conflict is likely to be positive for the market, and the longer-term outlook is difficult to forecast at this point in time.

Europe

  • Eurozone inflation is on a declining trend, even as output in core countries remains weak. Continuing moderation in the consumer price index should extend into 2003, and even the vigilantes, in the European Central Bank (ECB), are now convinced of this outcome. If the Iraqi situation is resolved speedily and oil prices fall, so will inflation be lower still. Expectations are growing that the ECB will cut interest rates again in the first quarter, and the vibes coming from the central bank appears to confirm this view.

Asia/Pacific

  • Bank of Japan (BoJ) governor, Hayami, who is an inflation hawk, will be replaced next year, and this has raised the expectation that further monetary easing is in the works. This may involve government debt monetisation and unsterilised intervention in the foreign exchange market - - all good for raising inflation, in a deflationary economy. Meanwhile, GDP growth, next year, may remain flat to negative, depending on how vigorously the banking system’s bad-loan problem is tackled.

Bonds

  • Longer Treasury yields continue to experience volatility. The swings that we have recently observed are unlikely to be the last ones that we are going to witness, given the uncertainties with regard to the economy, the Fed, the stock market, Iraq and the terrorism question. At the back of every bond investor’s mind are lingering concerns about possibly higher inflation down the road, increasing government deficits, and a lower dollar. Meanwhile, a sharp rise in the price of gold is largely related to worries about rising geopolitical risk.

Currencies

  • The foreign exchange market’s perception is that the new Bush economics team is going to push for higher growth and won’t mind a weaker dollar. Of course, there haven’t been any announcements to this effect, and it is unlikely that there will be any intervention in the market. However, the administration may not be averse to normal developments taking their course, simply by refraining form enunciating a strong dollar policy. Anyone looking for a boost to the U.S. economy via dollar depreciation should note that the income effect is stronger than the price effect. In other words, output growth in the global economy will do more for higher activity in the United States than a moderate level of non-inflationary decline in the dollar.
  • Another issue is that substantial weakness in the greenback may scare off foreign investors who are needed to fund the large current account deficit. In such a case, U.S. assets would need to have higher yields to compensate investors for expected currency risk. This would be very unhelpful for the American economy, which needs low interest rates for a good stretch of time, to allow deleveraging and rebalancing by both the household and corporate sectors.
  • Heightened geopolitical uncertainties have increased the attraction of surplus currencies such as the Swiss franc and the yen. However, in the case of the Japanese currency there is a countervailing force, in the form of expectations of eventual BoJ easing.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.