2004 was a year of uncertainty and doubt:Financial outlook for 2005 [Archives:2005/803/Business & Economy]

January 3 2005

By Ibrahim al-Hashedi
For The Yemen Times

Investors were perturbed by the oil prices, which nearly doubled between January and October. The US benchmark WTI crude oil price rose from a little under $US30 per barrel to nearly $US56 per barrel. This price surge not only implies a loss of purchasing power for consumers but also calls into question the longevity of world economy growth.

While geopolitical uncertainties continued to pay a significant role in these developments, other events also cast shadows over the future. For Example, the well publicized difficulties encountered by the Russian oil giant Yukos raised doubts as to its capability to continue production.

Also, the repeated strikes in Nigeria and Norway hampered oil production, not to mention the bad weather conditions in the Gulf of Mexico, which halted production. The resulting low levels of world oil stocks as well as significant speculative positions also constituted additional destabilizing factors. While oil prices have eased from their highest levels they remain high by historical standards.

Further, the March 11 Madrid bombings brought terrorism back to the foreground, undermining the rebuilding of investor confidence following the events of September 11 2001.

Has the Chinese economy failed with its soft landing?

Another uncertainty began to worry investors at the end of the first quarter when the Chinese government declared it intention to slow the pace of economic growth. Chinese demand was one of the main engines of economic growth for the rest of Asia between 2002 and 2004, and sharp slowdown in Chinese growth, which was running at an estimated nine per cent in real terms, could have significant negative repercussions for the global economy.

All of these events have gradually eroded analysts' – confidence in the continuing economic growth for 2005, particularly in the US, and while 2004 looks set to be a very acceptable year in terms of earnings growth, investors are now focusing their attention on revising the 2005 earnings forecast.

The main equity markets have traded within a relatively narrow band of +5% to -5% during the greater part of the year. Emerging markets fared significantly better, with the notable exception of China, which recorded a negative performance as from mid-April.

For most of the year, equity markets did not favor and particular sector although after the summer a significant difference began to emerge as the energy sector posted a relatively strong performance. At present the best performers are those sectors whose 2004 and 2005 earnings forecasts have received the strongest upward revisions.

After reacting to signs of stronger growth in the US during the first half of the year, bond markets anticipated the economic slowdown, as they interpreted the rise in oil price as being a factor of slowing demand rather then of a general rise in consumer prices.

As a consequence of this interpretation, US long rates were at the same level in mid – November as at they were at the beginning of the year (4.2% for 10 year Treasury bond) despite an estimated GDP growth of at least 4% for 2004 in real terms, and four successive hikes in interest rate by the Federal Reserve which raised the intervention rate from 1% to 2%. At the same time, long rates in Europe fell by around 50 basis points (0.5%) thus highlighting the persisting gap between US and European growth.

The US Dollar remained weak during the major part of 2004. Despite an appreciation of the US currency against the Euro during the first half of the year when it moved from 1.29 to 1.18, it remained relatively stable in the 1.20 to 1.24 range until October when significant weakness again appeared and it broke through its previous record low of January/February 2004.

Economic growth is expected to return to normal levels in 2005.

We expect economic growth to return to normal level in 2005 and should be close to the potential growth level in most developed countries. US growth is expected to reach at least 3% in real terms while in the Eurozone, economic conditions are expected to continue to improve gradually with GDP growth of around 2%. A slowdown is likely to be more pronounced in Japan where, after a year driven by strong external demand in 2004, growth might fall from 4.2% to 2%. Although consumer prices are like to rise faster in coming months, inflation is anticipated to remain under control at around 2.5% in all the main developed countries. China appears to have managed to stabilize its growth and should continue to be a strong center of activity.

Under these conditions, earning growth will probably slow somewhat. Corporate earnings could suffer from a “scissors effect”, with slower growth in sales and pressure that should remain moderate, on production costs. Thus, after reaching levels of 15% to 20% in the US and Europe this year, earning growth is likely to slow to between 8% and 12% in 2005.

Interest rates likely to come under tension

Despite an expected slowdown in the world economy for 2005, long rates are not yet at a level of equilibrium. The yield on 10-year is well below 4.5% while nominal growth is at least 5.5% i.e. GDP growth of a little more than 3% in real terms plus inflations of 2.5%. It is therefore likely that interest rates will tighten rates over coming months. Although the economic environment in continental Europe does not necessarily call a similar movement, it is possible that European long rates will follow, at least in part, the US example. The overall context therefore, calls for a certain amount of caution with regard to long bonds over coming months.

Turning to the equity markets, these seem attractive relative to the bond markets in terms of valuations as compared to 2004, when the increased appetite for risk focused more on emerging market bonds rather than equities.

Price/earnings ratios on the main indices are at reasonable level on a historical basis, and a moderate rise in long bond yields could be absorbed. Like economic growth, the equity markets' performance could return to its historical level of around 10%.

Possible obstacles

Apart from geopolitical events, which are difficult to factor into a forecast, any major dollar crisis would also call the above markets scenario into questions. The large US deficits require a constant inflow of foreign capital, which a sudden fall in the dollar could bring to a halt.

Under present conditions however we think that such a crisis is unlikely. First, the US Federal Reserve will continue to tighten its money policy.

At present dollar short rates are identical to euro short rates despite having been lower for more than three year. The interest rate differential is therefore less unfavorable to the dollar.

Second, Asian central banks wish to keep their currencies relatively weak against dollar and they will therefore continue to finance the US deficits over the coming months.

Finally, purchasing-power parity shows that the Euro is overvalued by around 10% against dollar, and while this is not an indicator of short-term trends in a currency, it is nonetheless a driving factor for the medium term.

In summery, 2005 looks set to follow in the same trend as 2004, but with a clearer macro-economic outlook.