Strong response expected from World equities in 1996

World Economic Outlook

The following is intended to provide an overall view to the world's markets to develop a basis to formulate an investment strategy.

With the fall of communism, symbolized by the falling Berlin Wall in 1989, the world has moved into a phase of consolidated growth. Lead by the US recovery from recession, the remainder of the millennium looks to be a period of increasing productive capacity and low inflation.

The emergence of new economies into the capital markets coupled with advancement of technologies improving production quality and speed, has forced us to recognize that what was normal before must now be adjusted to reflect the new normal, the global village concept.

High Demand

With over 3.2 billion people in Emerging Growth Economies seeking improved life styles and with many political and economic policies in place to fuel private sector growth, the world is poised for very positive economic gains. Accounting for 48% of the world's GDP, growing at 6-8% per year (three times the developed country average) and valued at only a fraction of the world's capital market value, the developing economies clearly have tremendous potential for growth as their value is realized. In addition, imports to the G7 countries have been steadily rising since 1982, supporting the theory that developing countries are increasing in wealth.

More Consumers

A growing middle class in the developing economies will provide exceptional consumer spending potential. For example, by the year 2000, India is expected to have a middle class population of 300 million people, the size of the total population of either Europe or North America.

High Supply Capability

World production capacity, not country production capacity, will dominate inflation as companies move to capitalize on ever-reducing trade restrictions. Global capacity utilization, efficient production and commodity abundance will negate inflation and force long term interest rates to remain low.

Low Inflation

Global monetary conditions continue to support a non-inflationary environment. Year after year, global money supply is increasing at a slow and steady rate, near 3.5%, revealing a lack of liquidity. The shortage of money, coupled with global competition will force prices to stay low. This is further supported by the 7% growth in global trade experienced over the last year when compared with the smaller 3% growth in global output.

Low Interest Rates

There is simply not enough money to have inflation. With Japan and Germany looking to stimulate their economies further, and with the US in stable growth, there appears to be little need to dramatically change short term rate policies with continued easing of monetary policy expected in Europe.

Low Wages

With improvements in technology and product quality in the developing countries, and an abundance of inexpensive and increasingly skilled labour, there is little room for much increase in wages.

Steady Growth to the Year 2000

1996 should be a year of continuing flow of privatisation investment opportunities, particularly in Europe and the Asian region where market evaluations are low and where we expect further market recovery. The US has now reached more reasonable valuations with the smaller companies showing the greatest gains. We expect smaller companies on a global scale to respond favourably in the growth period forecast for the next few years.

Stocks will Dominate Gains

Given the restructuring of corporations toward core business and the more recent development of export driven growth for both large and small companies, the next five years look to be a period of strong performance by the equity markets with the best value being seen in the Far East and some European special situations. Smaller companies will continue to establish themselves on a global basis as the future demands quality products and services from speciality suppliers, ultimately becoming the performance leaders.

Major Risks

Too rigid a monetary stance by governments could slow the major economies too much and could lead to a deflationary spiral, further compounded by excessive government deficits, leaving little scope for fiscal stimulation.

Excessive Government Deficits

Particularly in Europe, this needs to be cut. However, to date, few governments have effectively reduced the excessive levels of government expenditure, essentially because politicians are afraid to cut unsustainable levels of welfare expenditure.

Major Markets
Economic Overview

United States: We expect the US economic growth to continue through the decade at reasonable rates, with a tendency toward accelerating past the 3.5% GDP limit set by the Fed, rekindling some inflation concerns.

In the short term, it is important to note that corporate earnings growth is predicted to be only 7% in 1996, down from the 18% year to year growth seen over the past few years and which formed the basis for the strong US rally seen in 1995.

For this reason, we expect stock values to grow slowly in 1996 in the US as profits are taken and capital moves to better value in other regions. New York PE ratios have reduced with strong profits' growth, but Wall Street is not cheap. We are down weighting our US exposure to 25%.

US companies will continue to lead the world in areas supplying technology and services. Companies which facilitate, develop or improve infrastructure and manufacturing capabilities in other regions should be the focus in your US holdings. In addition, we note US interest rates continue to have a high real rate of interest, yielding over 3% real growth above inflation. US bonds remain attractive for the short term but whether the Fed tightens or eases, the end appears to be near for bonds with rates climbing later in the year.

If interest rates should fall, they will fall very slowly, both to avoid the risk of overheating and to support the currency, at least until the Dollar has strengthened significantly. We expect a repowering of the US economy at some point with rates climbing later in the year. Almost all of the rise in US inflation has come from food and energy prices, as well as the normal cyclical expansion of profit margins.

Labour costs are up by a mere 0.4% in the last year. As a result, we expect inflation to dip below 3% in the near term. However, as the economy powers back up, inflation may well have another run at the 3.5% area by spring.

Europe: Continental Europe's governments have been slow to adopt economic stimulus programs to accelerate growth. Clearly, growth is slowing in Germany more than the Bundesbank expected. The worldwide boom for capital goods, particularly from the emerging economies, has also slowed, and is impacting on the German economy, in particular, which is also being hit by an overvalued DM and the slowdown in the recent property boom.

Lower interest rates and the prospects of rising monetary liquidity should be positive for financial asset prices - both bonds and equities.

The limitation here is that equities in Continental Europe seem close to being fully valued, assuming lower than previously expected corporate profits growth. For virtually all of Europe, domestic consumption is flat with growth depending on rising exports.

Japan: Over the next five years, Japan will be the key player in the Pacific Rim as it moves to world manufacturing dominance. Japan's deflationary contraction, threatening to turn into a serious debt-inflation depression, may well be the catalyst that sparks the stimulus from government much like the US savings & Loan bail out sparked the US recovery in 1990.

If, as remains likely, the Japanese authorities accept the need to increase monetary liquidity, which has been tightening since the beginning of 1994, it can also be expected to lead to a bursting of the Yen Bubble. The Japanese government has stated that they will print money to sell yen at 100 to prevent any further strengthening of the currency.

The long term view for Japan does not look so favourable. Unusual accounting practices make it difficult to access value. Japan's dependence on imports will begin to decrease as resource-rich countries develop value-added industries and curtail commodity supplies. This, together with a dissatisfied consumer population, an aging population with its inherent pension problems, and political uncertainty, will move Japan toward major change.

Far East: In the Far East, we continue to forecast growth rates in the 6-8% range for the major South East Asian countries, and expect the other countries to generate respectable growth rates around 5%. Corporate earnings are expected to benefit from increasing exports to recovering economies at a time when intra-regional trade also remains buoyant. Earning ratios of approximately 10 for China, 12.5 for Hong Kong, 14 for Thailand and 18 for Singapore compare favourably with those in the rest of the world and we see this as the number one region for investors looking for value.

The reluctance of governments to privatise companies in down-trending markets over the past two years should ease, providing expansion in the equity markets as well. Common sense says value has been created in Asia with companies trading as cheap as 40% of book value. We are overweighing Asia due to consistent high economic growth and good valuations.

Latin America: Generally suffering the fall-out of the Mexican crisis, albeit that the real economies are in reasonably good shape. Offering tremendous growth potential we note that most research and analysts still consider this region a long term hold, indicating the jury is still out.

Select opportunities for excellent returns remain attractive but in general we view the region as over a long term investment and would recommend exposure via mutual funds with a partial weighting to the region allowing the manager some room to manoeuvre quickly.