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15 October 2003

World economy avoids deflation pitfall

"Equity investors have peered into the deflationary pit and decided it was not as deep as they feared."

Over the past three months there has been more optimism over the prospects for the US economy in 2004 and growth estimates have risen from the 3.0% level in June to around 3.8% now.

Retail sales have remained firm despite weak employment growth, there are signs of improving capital expenditure and the productivity numbers are showing significant improvements. These trends have not yet been reflected in the UK and Europe where growth forecasts have been marginally reduced over the same period but in these areas too there are signs that the worst is over.

The biggest surprise has been in Japan where growth led by exports and capital expenditure has exceeded estimates causing large upward revisions in forecasts for this year and next from a fall in GDP to positive growth of around 1.5%

Investors' concerns over future deflation have now been laid to rest. Nowhere is this more evident than in the performance of the US bond market where yields have risen from a low of 3.1% a few months ago to the current level of around 4.2%. The Fed has indicated that it will continue to hold short rates low at 1% and this combined with tax cuts should ensure that the economy does not have a relapse.

While bond prices have fallen equity markets have celebrated the recovery in economic growth prospects with rises, currency adjusted, in the major markets over the past six months ranging from 18% in the US to 37% in Japan. As a result the extreme cheapness of equities relative to bonds has largely been corrected. Equity investors have peered into the deflationary pit and decided that it was not as deep as they may have feared.

Allied to the improving economic news, perceptions of the outlook for corporate profits have taken a turn for the better. Companies in most parts of the world have been declaring earnings slightly ahead of forecasts and analysts have been increasing their forward projections.

So far profit improvements have largely come from cost savings but after the major restructurings and write-offs of the last couple of years a modicum of real sales growth could have a disproportionate effect on profits. US company profits have now been growing for four quarters in a row.

However not everything on the economic front is benign. Consumers in the US and UK are still highly indebted and so consumption could be vulnerable to rising short term interest rates, particularly in the UK. Of greater concern are the US twin deficits on the budget and current account.

These are at record levels and although they appear to be unsustainable they have continued to rise. This could lead to a sharp fall in the dollar which would have a serious impact on growth around the world.

Although share prices are no longer significantly undervalued they are not over-priced for what is probably the early stage in the economic growth cycle. Further progress is contingent upon continued recovery in corporate profits. There are signs that investors are recovering their nerve and flows into equity funds are improving strongly, particularly in the US.

Ian McLeish
Manager
The Scottish Investment Trust PLC