JPMorgan Asset Management global outlook

The following comments are by David Shairp, Global Strategist at JPMorgan Asset Management:

Pick up in volatility: 2006 has seen the Vix falling to its lowest level in 12 years. Only in late 1993 has it been lower. However, 2007 could be the year when volatility finally rises, with impacts on financial market performance. Overall liquidity conditions are expected to shift from their current state of being adequate to finance global activity and asset market performance, to one where asset prices become more volatile. This is by no means a recipe for disaster. Nevertheless, it does suggest that it could be harder to generate good investment performance in 2007 and investors will need to be careful in selecting the best quality funds and asset managers. It also suggests that convertibles will do well in 2007, while it suggests being cautious on high beta assets. Investors should overweight core equity markets, focusing on large cap stocks with strong free cash flows.

Large caps look attractive: Valuations of large caps in core markets (especially the US, Europe and the UK) are looking very attractive, both versus their own history, versus small caps and versus bonds. Given that uncertainty in the markets is rising and that risk appetite will remain fragile, we expect investors to prioritise earnings quality and strong free cash flow generation. At the same time, with returns likely to be modest, investors are likely to put more stress on superior dividend yields and also dividend cover. All of this favours large-cap blue chips. Conversely, small caps are likely to be more sensitive to a slow down in economic growth and momentum, and this has resulted in an emphatic underweight of US small caps.

Corporate earnings – the new conservatism: An interesting trend has been in place during the 2000s. This is the tendency of investment banking analysts to understate earnings growth expectations, with the result that they have to be revised upwards during the year. This trend contrasts with the 1990s, where there was a tendency for estimates to be too optimistic at the start of each year.

The corporate sector still has plenty of ammunition it can use to enhance earnings growth going forward. Balance sheets generally remain in good shape, while returns on equity for the largest 120 companies have reached 21% according to UBS data. Companies can use this ammunition to re-lever their balance sheets to ensure that ROEs are maintained, even in the face of potential margin pressures. As a result, earnings growth is likely to be sustained. In short, the corporate sector has greater ability this time round to preserve their earnings track record and analysts could once again prove to be too conservative, even in the face of slower economic growth.

Japanese equities – the wild card? The big disappointments this year have been Japanese assets, which have confounded many investors. While the yen and JGBs have both reportedly been nightmares for the macro hedge funds, equities too have been a major disappointment with the result that Japan has been the laggard among the major markets. But the worm may be beginning to turn. Recent price action left the Japanese market looking the most oversold relative to global equities it has been since October 1998. Moreover, investor survey data show that institutions reduced their Japan equity positions throughout 2006, to leave them with their lowest weightings since 2003. In short, the market has become oversold and unloved.

The fundamental picture is mixed but is suggesting that things are turning for the better. Signs of stronger industrial output in early December suggest that activity may be firming. One important catalyst could be any evidence that earnings growth will remain robust, following a good first half of the current fiscal year. However, corporate guidance indicates that earnings growth will be negative in year-on-year terms for the second half. The outcome is likely to be rather better than these lowly expectations, with the result that analysts could upgrade their estimates, giving the market a boost. Meanwhile, valuations have become more supportive, with multiples well below their medium-term average, while at a stock level about 30% of the market trades on a price to book of 1x or less. The risks remain in the form of draining liquidity, with monetary growth, looking inadequate compared with economic activity, but the risk/reward mix is now moving back in Japan’s favour.

Growth convergence: The world economy is slowing as we go into 2007. This has been apparent from the lead indicators of activity and from the forward survey data, which mostly capture the movement of an industrial economy on the wing. Our sense is that this deceleration does not spell the end of the current business cycle, but is merely an inventory shake-out in the major economies, where output growth will slow to work off excess stocks. Mainly found in manufacturing, this inventory overhang is also apparent in the US housing sector. It is expected to take 2-3 quarters before overall activity will re-accelerate in the second half of 2007. The implication of this is a degree of growth convergence. It is notable that our monthly consensus of 10 leading sell-side institutions is forecasting 2007 real GDP growth approaching 2% for the US, Euro zone and Japan. If this trend is confirmed, then this could lead to greater levels of currency volatility in 2007, as it is far from clear there has been similar convergence of trend, or potential, growth rates.

European policy error? One of the risks we have identified in 2007 is that the European Central Bank ends up tightening monetary policy too much. That proposition appears odd at this stage, given that interest rates have been raised by just 125bp to their current level of 3.5%, and given the acceleration in real GDP growth to above trend. Any further tightening above the “final” 25bp priced into markets in early 2007 (to take rates to 3.75%) could easily be “overkill”. However, sell-side analysis suggests that the neutral rate of interest has fallen over time and that current policy rates have indeed reached or exceeded their neutral level. Moreover, our monetary conditions indicator suggests that Euro zone monetary policy is the tightest it has been during the life of the ECB.

Any policy error would arise from an inappropriate fiscal/monetary policy mix. Higher VAT in Germany and tax rises in Italy mean that overall fiscal conditions in the Euro zone will tighten from being slightly easy to being slightly restrictive in 2007. Coupled with a restrictive monetary policy, this suggests that the risks to growth lie on the downside. Investors will therefore need to make sure that the ECB does not “overdo” it. If it does, then investors will need to keep a close watch on the economic and corporate data for any signs of weakness, should the central case of slower, but decent, rates of activity not pan out.

UK roller coaster. By contrast, with the Euro zone, UK monetary policy looks to be overly accommodative. The sight of annual money and credit growth reaching 16-year highs, suggests that monetary conditions are loose, although some would argue that much of the credit creation has been directed towards the alternative fund management industry (hedge funds and private equity firms). Our monetary conditions work endorses this impression, suggesting that monetary policy may be rather easier than suggested by the market. With fiscal policy currently accommodative and with a very limited withdrawal of this stimulus signaled by the Chancellor in his pre-Budget speech in early December, this suggests that the UK policy mix is skewed towards faster growth, possible overheating and potential inflation pressures.

This suggests that the Bank of England may not be done in terms of interest-rate increases, despite the pause at the December MPC meeting. The consensus is looking for one more increase in rates in early 2007 to take the base rate to a final 5.25%. Firmer house prices, improving household net worth, allied with a credit boom suggests that growth could overheat, necessitating further rises. As one sell-side analyst put it, there is a “non-trivial” probability that interest rates may peak as high as 6% – even if that is not the central-case scenario. Such an outcome could play havoc with sterling, which already looks to be overvalued. 2007 could thus be a roller-coaster year, with markets pricing in more policy tightening required in the first half, then anticipating much softer growth in 2007/08.