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Equities to outpace bonds in positive global outlook

Equities to outpace bonds in positive global outlook < News < Bet On Markets

On a 12-month investment horizon, global equities are likely to outperform global bonds, with previous laggards leading the way.

BoE Private Clients advocates a regional bias to Japanese and European equities over US equities, consistent with its view that the dollar will continue to weaken given the structural economic woes with regard to the record high twin deficits. It favours stocks with a defensive bias and a good dividend history.

Recent data suggests that US earnings growth momentum is slowing as the Federal Reserve increases interest rates.

Corporate profit margins are starting to decline as higher energy costs erode profitability. Equity valuations, however, paint a less pessimistic picture.

«We remain optimistic that global growth will be driven by China and the US».

The recent rally in US treasury bond yields to around 4.2 percent from 4.87 percent in the middle of the year has given equities the edge on a earnings yield ratio analysis. (This is the quotient of the bond yield divided by the share earnings yield.)

Japanese equities continue to benefit from improving corporate profitability and widening profit margins. Corporate sector restructuring has further added to our positive view as hiring trends are shifting to part-time employees, reducing labour costs.

A decline in corporate bankruptcies bodes well for the banking sector as it assists in the sector’s rehabilitation process. In addition, the positive cash balances on corporate balance sheets suggest that companies may increase their dividend pay out to shareholders or increase capital expenditure plans.

This will have a positive impact on the consumer and the economy.
Our view that China’s economy will continue to expand at between 7 percent and 8 percent a year should support demand for Japanese goods and services.

Despite the unexpected downgrading of second-quarter growth, the economy is poised to resume its up trend. Pan-European corporates have seen an increase in cash balances to the highest level since the bear market started in 2000.

Operating margins are expanding while earnings growth remains above 10 percent. The improved earnings is a result of better global demand evident in the robust export data. This has largely offset the anaemic economic recovery in euro land.

As with any scenario, however, there are risks.

Firstly we caution that crude oil prices at elevated levels will weigh on US investor sentiment. Secondly, a sharper than expected slowdown in earnings growth will put downward pressure on share prices. Thirdly, geopolitical risks will increase the risk premium.

Fourthly, a sharp increase in consumer prices in 2005 as companies transfer higher energy costs to consumers will ignite inflationary concerns.

If macroeconomic data out of the US do not back up the Federal Reserve’s view that the economy is recovering from a soft patch, equities will be punished.

We remain optimistic that global growth in 2005 will be driven by China and the US, albeit at lower than initially anticipated rates. We believe that Chinese growth between 7 and 8 percent and US growth of 3.5 to 4 percent will be positive for commodity markets while a weaker US dollar will further underpin demand for commodities.

The resurgence of commodity prices is an indication that the global economy is healthy despite recent concerns about the pace of recovery. This indicates that the US, the biggest consumer of goods and services, may be emerging from its soft patch.

By Quaniet Richards

Quaniet Richards is the global investment strategist at BoE Private Clients

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