The first major financial event of the year - the birth of the euro - has got 1999 off to a very smooth start. Unfortunately, this is unlikely to be the start of a trouble-free year for financial markets given the greater than usual uncertainties facing the global economy. Most investors will have read the end-of-year reviews and forecasts of future market returns. Not surprisingly, there is usually a wide range of forecasts of end-year stock market levels. It is difficult to disentangle the positive and negative cross-currents impacting financial markets and it is even more difficult to assess whether the positives will be in the ascendant during 1999. The problematic factors currently facing stock markets include: slowing global economic growth and a relatively high risk of recession; the appearance of some major financial imbalances over the past year; and, ongoing structural problems in many of the weaker economies such as Russia and Brazil.
While an outright recession should be avoided in 1999, much slower global economic growth seems almost certain. Japan and the bulk of the rest of the Far East remain in deep recession. The best the optimists can hope for is that Asia will bottom out during 1999, but the prospects of this occurring are at best 50:50. The US economy in 1998 had another very strong year with economic growth now estimated at 3.4 per cent. It is widely expected to slow this year and the hope is that it will slow to its long-term trend rate of growth of 2 per cent to 2.5 per cent. However, the risks of much slower growth than this are high, particularly if the Asian economies continue to deteriorate.
Regarding economic growth, Europe is more favourably placed although it does present something of a mixed bag. The euro zone should experience moderate economic growth but there are worrying signs the underlying momentum of growth is very fragile. Economies outside the euro zone present a much more mixed picture. In particular, the British economy is forecast to experience economic growth of just under 1 per cent during 1999.
Typically, a cyclical slowdown in economic growth will put downward pressure on corporate profits and 1999 will be no exception. In addition, there would seem to be longer-term structural forces at work which have created ongoing deflationary pressures. This means that companies are finding it very hard to increase their selling prices and their profit margins are being squeezed lower. Another worry for markets is the emergence of some major financial imbalances in the global financial system. US consumers are borrowing more than they save so that their net savings ratio has now turned negative. This cannot continue indefinitely and when it does begin to reverse, consumer demand in the US could fall very sharply.
The structural weakness of the Japanese banking system is a major factor holding back recovery in Japan. Many of Japan's banks are technically insolvent and despite government action to close down and nationalise banks, the crisis is still a long way from being solved. Despite the many problems facing financial markets, share prices in the US and Europe have risen sharply in recent months and are in many cases now close to all-time peaks. This has occurred in an environment where analysts have been revising down their forecasts of corporate profits. This means that equities are now looking very expensive with price-earnings ratios at very high levels.
The explanation for such high share prices would seem to lie in three positive factors, namely:
declining short-term interest rates and bond yields mean that even at current high share prices, equities offer returns that are likely to be better than those available from bonds and bank deposits;
the flow of funds going into equities either directly or through funds is buoyant and therefore there continues to be a strong underlying demand for company shares;
in Europe and the US, company balance sheets are in a very healthy state.
During 1998 the positive factors clearly overcame the negatives to produce another year of very strong market returns (excluding the Far East and emerging markets). It is likely to be a much closer call during 1999 with the positive and negative factors being very finely balanced. Therefore, a volatile year for stock markets would seem to be in store although the eventual outcome should see stocks produce somewhat better returns than cash or bonds.
