Turbulence forecast for 2008

Gary Dugan of Merrill Lynch advises brave investors to retain cash to buy undervalued assets, writes Simon Carswell, Finance Correspondent

This year will be turbulent, a year for brave investors and a time to diversify outside Ireland into new areas and countries, according to one of the most senior investment advisers at investment bank Merrill Lynch.

There will be opportunities to invest in undervalued assets this year, says Gary Dugan, managing director and chief investment officer of global wealth management at the bank. However, investors should not rush into emerging market equities as they will remain overvalued, he says.

"You might have bought a lot of risk in the past, but you shouldn't be so exposed to risk going forward. You should think back to some of the old asset classes such as equities - equities in developed markets, not emerging market equities," says Dugan. "You have got to leave India and China alone for a year or so until they get back to much more attractive valuations, considering there is still significant political risk in these countries."

Dugan advises investors to retain cash to be in a position to buy undervalued assets this year.

Persistently high inflation will bring opportunities to invest in commodities. "There are very few places to hide when inflation is picking up, so commodities have got to be part of that portfolio."

Dugan advises investors to look to Japanese equities and commodities related to biofuels. He says agriculture will give strong returns of 10-20 per cent a year.

Dugan also believes gold and oil will fall in price later this year. Merrill Lynch is predicting an average price of gold of $750 (€511) an ounce in 2008 and an average oil price of $82 a barrel. This is a significant retreat from recent highs of $914 and $100 respectively.

Despite the liquidity crisis and turmoil in the money markets, Dugan believes there will be opportunities to invest in financial stocks in six months' time, although it will take a "brave buyer" at this time as he does not expect positive news for financial institutions for another year.

Dugan says investors should not see falling property prices as "a little bit of a setback" for the sector. He expects property prices to have fallen by between 20 and 30 per cent by the end of next year.

Dugan attributes the surge in property values around the globe over the past two decades to the abundance of money available to purchasers. "The last 20 to 30 years will be seen as a time of immense money creation and we will not have that going forward; we will get more normal conditions," he says. "Property will never go back to this serious overvaluation we have seen in recent years - it was a reaction to money supply growth."

Inflation will remain above 4 per cent in the first half of the year, Dugan predicts, but he says the European Central Bank (ECB) would be "crazy" to increase interest rates "in the face of the money market problems". He says the ECB would have already increased rates had these problems not existed, given that inflation has risen and is likely to rise further.

The ECB is facing "a unique battle", says Dugan, because it is a relatively new organisation and has never before experienced the money market conditions that currently exist across Europe.

On the other hand, he believes there won't be a chance of a cut in interest rates until May or June at the earliest, at which point the credit crunch will have eased and the European economy will have weakened.

Dugan expects the subprime mortgage crisis to be beyond its worst point by the end of the next quarter as banks call their writedowns more accurately.

One area of concern for businesses in Ireland is a weaker sterling, which will create problems for Irish exporters.

Dugan says the UK housing market is "unwinding" and the slowdown in the US and British economies has not yet been fully absorbed. This will create further unemployment, driving down sterling. "Companies are only just starting to recognise problems," he says.