Fiduciary's Global Overview

KEY POINTS

• Global equity markets posted good returns in 2005, aided by decent global GDP growth, still robust earnings performance, and modest core inflation despite higher energy prices. The US equity return was a modest 4.9% whereas non-US equities returned 14.0%. Stockmarkets in local currency generally had a very robust year. By contrast, US and global bonds lagged equities, up 2.0% and 5.4% respectively in 2005. For 2006, we expect that stocks will continue to outperform bonds.

• Global GDP appears to have grown in excess of 4% last year. We’re forecasting growth slightly below that for 2006, with the largest contributions coming from Asia and the US. Over time, we anticipate that global growth will be less dependent on the US consumer and more on the Asian one. Profit growth will likely slow in 2006, though we expect that profit margins will continue to expand, mainly due to good US labour productivity performance and the globalised labour supply. These are also the two primary reasons why we think that core inflation measures will ease modestly into 2006.

• The Federal Reserve continued to raise interest rates in 2005, to a 4.25% Fed Funds rate; we expect a 4.75% rate into 2006, after which we think that the central bank will move to the sidelines. As the Fed continues to tighten, we look for long-term interest rates to rise further, though within the context of a flattening US yield curve. In our view, the European Central Bank will probably boost interest rates one more time. In Asia, we expect the Bank of Japan to move away from quantitative easing as core deflation gives way to sustained core inflation.

• The big surprise in foreign exchange markets last year was dollar strength. In 2006 we think that dollar strength will abate as the Fed nears the end of its tightening regime but we are not looking for significant dollar weakness. Rather, we expect the primary currency event of this year will probably be the revaluation of Asian developing country currencies. In our view, such revaluations will provide for better and more balanced global growth and should be positive for global stocks.

GLOBAL FINANCIAL MARKETS

Global stockmarkets had a fairly good 2005 despite much higher energy prices and continuous tightening by the US central bank. The Federal Reserve raised the Fed Funds rate from 2.25% to 4.25%, signaling at year-end that it was nearing the end of this tightening regime. And crude oil prices rose 40% last year. But these negatives were more than offset by large macro positives: another year of good global growth, double-digit profit gains, and well-behaved core inflation.

Although we do not yet have all economic data for 2005, real global GDP growth was likely in excess of 4%. US growth exceeded expectations, Japanese growth improved, and even Europe began to pick up at year-end. The best growth, however, continued to come from developing countries. As a corollary, profits advanced handsomely, up 13% by our estimate. Moreover, core inflation barely budged despite much higher energy prices; indeed, core inflation figures began to decline into the fourth quarter.

As a result, local and global equities posted positive returns last year: in the US, the S&P 500 index total return was 4.9% and global stocks, measured by the MSCI World, returned 10.0%. Non-US stocks, measured by MSCI EAFE, did the best, returning 14.0%. Most stockmarkets in local currency terms had much higher returns. Bonds, by contrast, struggled during 2005: the US 10-year Treasury bond return was 2.0% and global sovereign debt returned 5.4%. For 2006, our fundamental outlook is that stocks will once again do better than bonds.

Our various financial market models also point in that direction. One model is the earnings yield gap (EYG) which measures the difference between the forward earnings yield on the market '” the 12-month forward earnings forecast expressed as a yield on today’s global stockmarket price '” and the yield on the global 10-year swap rate. As chart 1 shows, the global EYG was 2.8%, a level normally associated with the outperformance of stocks to bonds.

Other models we use '” flow of funds-based, fair value, and cash flow models '” lead us to an expectation that global equity returns will likely outpace global bond returns in 2006. For example, the global total cash flow yield, a measure of the use of corporate cash expressed as a yield on global equities, points to positive forward global equity market returns (see chart 2).

ECONOMICS AND PROFITS

The global economy appears to have expanded in excess of 4% real growth last year, a deceleration from 2004 but a healthy advance nonetheless. And that was achieved in the face of higher dollar-bloc interest rates and much higher energy prices. The primary reason for that good growth is very robust economic advances in developing countries. Although US economic performance exceeded expectations, our economic consultant, Dr Robert Barbera, notes that in aggregate, developed economies have been growing by 1.5%, accounting for 55% of global GDP. By contrast, developing economies have been growing in total by 6.5% and represent 45% of global GDP.For 2006, Barbera is expecting that the 2005 rise in energy prices will hamper consumption, leading to growth slightly below 4% (see table).

We are also expecting a modest drop in global inflation next year, partly because we are forecasting average oil prices close to the 2005 level but, more importantly, due to the positive impact of good US labour productivity and a globalised labour supply on overall price levels.

Indeed, US labour productivity performance accelerated in the third quarter last year, confirming again that this has been the best productivity performance of any US business cycle. Unit labour costs were back in negative territory, which, as we see it, will not only help keep core inflation low but probably push it even lower (see chart 3).

On a longer-term basis, moving away from this business cycle and to a more secular focus, there are reasons to expect US consumer spending may not be as robust going forward as it has been over the past couple decades. Barbera notes that consumer spending has consistently outpaced consumer income growth for 20 years. Many commentators have bemoaned the household debt growth that has accompanied that robust consumption.More importantly, we think, Barbera observes that household assets have grown even faster than debt, with the result that household net worth to disposable income has risen substantially since 1985 (see chart 4).

This ratio has also been a fairly good explanation for changes in the household savings rate over time; that is, households are rational economic actors. Therefore, it is worth briefly discussing the likely future changes in the value of financial and real estate assets; together, they comprise 80% of household assets.

Financial asset values have benefited hugely from disinflation since 1985 through much lower long-term interest rates and price/earnings multiple expansion. We think, going forward, that propellant to higher than normalised financial asset class returns will be absent. As for real estate, history suggests that frothy housing markets more often stall than bust. Thus, the key asset classes '” financial and real estate '” which have helped fuel consumption in excess of income growth for two decades, are unlikely to contribute commensurately in the future.

If correct, this not only has implications for the trajectory of US consumption but also the global economy, reliant as it is on the US consumer. In turn, tamer US consumption should make the burgeoning household wealth creation in developing Asia even more important to global growth going forward.

Meanwhile, the profit outlook, while slowing, still looks pretty good. Forward profits expectations, with exception of one month, continuously improved in 2005 despite the rise in energy prices. At the start of 2005, the 52-week expected EPS was around $74; at year-end, it was approaching $86. In addition to good global growth, the other primary reason for this profit performance was well-behaved labour costs locally and globally. For 2006, we are forecasting a slowdown in EPS growth from 13% to 9%, or $82, well below the consensus forecast of $86 (see table 2). That forecast is derived from our expectation of slower global growth and inflation in 2006 but continued margin expansion.

INTEREST RATES AND CURRENCY

In 2006, we expect the Federal Reserve will continue tightening monetary policy, taking the Fed Funds rate to 4.75%. With core inflation measures running about 1.5–2.0%, this should achieve the central bank’s goal of getting the “real” cost of money into the neutral range, which we estimate is a real interest rate of about 3%. Along the way, we expect the 10-year Treasury bond yield to rise modestly as the yield curve flattens further. Outside the US, we believe that the European Central Bank will probably tighten once more and the Bank of Japan will likely adhere to its policy of quantitative ease until core deflation is supplanted by sustained core inflation, which could occur in 2006.

In the foreign exchange markets, we expect the dollar in 2006 will no longer be supported by a rising interest rate differential. However, we’re not of the view that we are in for a big dollar bear market. The US current account deficit, while huge, has not proved difficult to finance, given that the US has remained a desirable destination for private sector capital and many Asian nations have supported their undervalued currencies by buying US debt.

That said, we continue to believe that the secular currency event will be the revaluation of developing Asian country currencies to developed country currencies, as long as those nations continue to grow faster than developed countries. The recent news that China’s economy is 20% bigger than anybody thought is, in our view, further confirmation of that secular trend. And we think that such currency adjustments should facilitate more balanced global growth and thus be positive for global equity markets.

EQUITY MARKET SECTOR

During the fourth quarter of 2005, the best US equity sectors were materials and financials; globally leadership was in the financials and industrials sectors (see Tables 3 and 3a). The worst-performing sectors for the quarter were utilities and energy in the US. Globally, those same sectors underperformed with the addition of telecommunications Services. For the year in the US, the best performing sector was energy, followed by utilities; at the global level, the same sectors outperformed with the addition of materials. Locally and globally, among the worst performing sectors for 2005 were the consumer discretionary and telecommunications services sectors.

In terms of capitalisation, US small-cap stocks modestly underperformed large caps during the quarter, but small caps at the global level performed handsomely. Emerging market equities also had a great year, up 35% even when measured in dollar terms. Meanwhile, the growth equity style moved ahead of the value style in the fourth quarter but more so locally than globally. We had expected growth to pull ahead of value last year as further Fed tightening occurred, global yield curves flattened, and global growth slowed. It appears that got under way in the fourth quarter.

RECOMMENDED ASSET ALLOCATION

Our core asset allocation call for 2005, that stocks would outperform bonds, happily worked out all right. For 2006, based on our outlook for good global GDP and profits growth, moderately declining inflation, and only modest interest rate moves from the key central banks, we expect that stocks will, once again, provide superior returns to bonds. If correct, this will be the fourth year in a row.