Cash in the bank or better returns?

In the last few years, equity investors have either reaped the rewards or taken a pounding. So, what are the prospects for 2005: another year of 10-20% stockmarket returns, or one where it would be better to leave cash in the bank?

The most popular assets in 2004 were emerging market equities, commodities, corporate bonds and commercial property. Some markets continued to perform well, extending a run that had started the previous year. Now, however, it is unclear whether there is as much long-term value in many assets as there was around the time of the Iraq war.

On the plus side, many equity markets remain attractive. For example, in Britain the combined dividend yield plus the value of share buybacks is running at about 4% a year. Even discounting any future increase in dividends, this compares favourably with an inflation target of 2% a year and a gilt yield of about 4.5% where the coupon has no chance to grow.

On the negative side, some areas of the corporate bond market warrant close attention. Spreads could narrow further as investors are reassured by the strength of company balance sheets. However, it is difficult to argue there is much long-term value, with spreads over government bonds at their lowest since 1997.

Our combined analysis of investor risk attitudes and market valuations leads us to conclude that a portfolio of more risky assets, including British, European and Pacific Basin equities, should be balanced by more defensive assets, such as index-linked gilts and European bonds. This view is based on the key assumption that the business cycle, and thereby solid corporate cashflow, will not falter in 2005. However, we do expect slower growth than was seen in 2004. In America, for example, households are no longer benefiting from the tax cuts granted by the last Bush administration, while energy costs are noticeably higher than they were 12 months ago.

Nevertheless, our own forecasts are similar to those of the Organisation for Economic Co-operation and Development, the International Monetary Fund and major central banks, namely that the coming year should be reasonable in terms of growth and inflation. We envisage global gross domestic product growth of 5-6% a year, slightly lower than 2004, but still above the previous year’s level. This should generate solid profits growth of about 10% a year provided no major obstacles emerge along the lines of the higher energy costs, which, in 2004, forced companies to scale back recruitment.

The outlook for the oil price remains unclear. Even small changes in supply and demand or in stock levels can lead to widely diverging prices. Our forecast is that the sustainable oil price in 2005 is likely to be in the range $35-45 per barrel, but could be as much as $10 lower or $20 higher than this central position. This is important as each sustained $10 move on the price affects corporate earnings growth by 1-3%.

Currency volatility will remain a theme for investors. Both Europe and Japan are susceptible to recession if the dollar continues to depreciate. The trade-weighted dollar index has fallen steadily since spring 2002 and we expect this to continue in 2005, albeit at a more moderate rate.

Just as potentially damaging as economies that grow too slowly are those that expand too fast and then slam on the brakes. The most obvious danger is China. The authorities there have controlled the economy so far, but there remains a risk of policy mistakes.

During 2005, there will also be new threats and opportunities. One concern is that markets have priced in a low probability of some major event disrupting markets. Such a crisis could take many forms – Middle East tensions, concerns about the American and British mortgage markets, or sharply rising bond yields, which could be damaging for debt-laden households.

By contrast, corporate balance sheets should be a positive theme. Although cashflow is strong, it is only recently that companies have started to use their cash in the bank for capital spending, inventory building or merger and acquisition activity. Instead, the emphasis has been on returning cash to shareholders and improving the strength of the balance sheet. If business spending increases in 2005, investors will feel reassured that the current upturn can be extended into 2006.

Standard Life Investments’ Focus on Change approach identifies major themes and risks, as well as triggers that we need to monitor. These will enable us to ascertain whether our central house view remains on track, supporting our balanced portfolio of stocks, bonds, cash and property.

We believe the outlook for the global economy is solid, with stronger growth expected in the America and Britain than in Europe and Japan. We also take the view that bond markets are overvalued relative to both economic fundamentals and stockmarkets, and we expect equities to outperform moderately on the back of robust earnings growth. ANDREW MILLIGAN Head of strategy at Standard Life Investments