Once again equities have been the best performing asset class in the internationally diversified investment stable. Average investment returns for the year 1997 to date have exceeded most forecasters' best expectations. Underlying these returns have been a set of macro economic, corporate fundamental and valuation characteristics which will once again drive the shape of investment returns in 1998. On top of the ongoing fundamental influences, some key themes have emerged over the period.
What has been described as the "New Paradigm", the combination of above average economic activity coupled with low inflation, appears to be feeding from the US into Europe. Nowhere has this been more prominent than in our domestic economy where we have continued to enjoy the benefits of strong economic growth coupled with low inflation. This positive dynamic shaped investment returns for most developed Economies (with the exception of Japan) in the first half of the year. However, over the same period, pressure was compounding in Asia and these problems came to the fore in the second half. Essentially the problem in Asia is that the continued growth in the region has led to the emergence of excess capacity.
The resultant disequilibrium can only be corrected by reducing the value of the currencies of the regions' economies in order to boost export competitiveness while at the same time slowing domestic demand. The average 20 per cent devaluation that we have seen in Asia and Latin America has directly impacted on the earnings of US, Japanese and European companies with exports to or operations in those economies. This in turn has put a check on international equity returns in the second half.
Finally, corporate restructuring, as a theme had been prominent throughout the year. This has been particularly the case in Europe, where industries such as Utilities, Financials and Publishing have begun what will be an extensive program of restructuring and consolidation on a Pan European basis.
Many of these themes will continue to shape investment developments in 1998. In the US, the key concern remains that the concluding phase of the current economic cycle may be prompted by overheating and that this will be marked by aggressive monetary tightening. Developments in Asia now make this less likely as companies selling into the region will experience some earning shortfalls into the first half of 1998. Nor does it look likely that inflationary pressures will accelerate significantly next year. On current evidence, the inflation position looks remarkably benign despite the continued fall in the rate of US unemployment.
The recent decline in global commodity prices will certainly help restrain overall inflation in the months ahead. This macro backdrop should provide a continued supportive environment for corporate earnings growth. However, how earnings growth transfers into equity performance is in part restricted by valuation constraints. The essential point here is that, on a Price to Earnings ratio of above 20 times, the market is leaving little or no room for any earnings disappointment in 1998.
In Japan, domestic economic recovery has been stopped in its tracks by an adverse combination of restrictive fiscal policy depressing domestic demand and a massive drop in competitiveness against a region which constitutes almost 30 per cent of its export markets. However the biggest issue facing Japan is the resolution of its banking problems.
On macro economic, corporate fundamental and valuation criteria Pan European markets look to be best placed to achieved substantial returns in 1998.
Irish equities can also be expected to distinguish themselves again in 1998. The economic backdrop with falling interest rates, a marginally lower trade weighted exchange rate and a very expansionary budget will continue to provide the stimulus for strong domestic demand and export growth next year. Certainly valuations both against domestic bonds and our international peer group are not as competitive as in previous years. However, any equity market which is likely to give you sustainable earnings growth of above 15 per cent more than deserves a full rating. We can realistically expect returns of close to 20 per cent from Irish equities next year.
Brian Gray, Director of Investments, Montgomery Oppenheim
