Slow global economic growth, a falling dollar and war fears are likely to inject an added layer of uncertainty into 2003.
The first few days of 2003 have witnessed a somewhat better tone to securities markets although the overall mood remains one of caution. As usual the newspapers over the holiday period devoted a substantial amount of space to "crystal-ball gazing" articles from economists, stockbroking analysts and business people.
After three years of negative stock market returns a more cautious tone than usual was adopted by many contributors.
Nevertheless, most commentators and financial analysts retain a positive bias and very few are predicting a fourth year of negative equity returns during 2003. Within the financial services industry there is still an undoubted bias towards predicting rising markets.
A more fruitful approach may be to focus on trends in some of the key macro variables that will be affecting the economic and financial scenario over the course of this year.
The possibility of war with Iraq and the fallout from the continuing war against terrorism will act to inject an added layer of uncertainty for the foreseeable future. On the economic front, several key trends emerged during the second half of last year in the currency and interest rate markets, and in the commodity markets. In the currency markets 2002 had a substantial, if gradual, decline in the value of the US dollar.
From the late 1990s onwards many analysts had been arguing that the greenback was overvalued. However, the dollar continued to appreciate up to early last year, mainly due to the lack of attractive alternatives.
This changed during 2002 as the dollar fell by just under 10 per cent on a trade-weighted basis and declined by a larger amount against the euro. In the early days of 2003, the euro/dollar exchange rate traded at 1.05 which is a long way from the euro lows of around 0.85 of early 2002.
The US economy is continuing to run an enormous trade deficit with the rest of the world and this will continue to put downward pressure on the dollar in foreign exchange markets. Further strength in the euro/dollar exchange rate now seems inevitable although an outright collapse in the value of the dollar seems highly unlikely. This is because the euro-zone economy is even weaker than the US economy and therefore there is not any overwhelming case to buy the euro in its own right. Rather, the euro is rising by default, as it is the main alternative to holding dollars.
As long as the dollar continues to decline at a moderate pace it will probably have a benign impact on global economic conditions. In particular, the stronger euro opens the way to further much needed interest rate cuts from the ECB. There are increasing signs that the ECB is becoming concerned about Europe's lacklustre pace of economic growth.
The strong euro provides the bank with the perfect rationale to reduce interest rates without compromising its anti-inflation credentials. With little prospect of any increase in US or Japanese interest rates, lower euro interest rates copperfastens an environment of ultra-low global interest rates for 2003.
Central banks are content to engineer such low interest rates because of the lack of inflationary pressures. But one area where prices have been rising is in the commodity markets. The oil price has soared over the past 12 months in response to worries about the potential disruption to supply if there is war with Iraq.
It is the rise in the price of gold, however, that has caught the eye of many investors over the past 12 months. Gold has traditionally been viewed either as a safe haven investment or a hedge against inflation or both. With global inflation so subdued, the recent rise in the price to around $350 (€335.8) an ounce would seem to be substantially due to "safe haven" buying due to heightened political tensions.
Furthermore, with equity markets so uncertain and bond yields so low, investors are desperate to find any investment that offers upside potential. Up to the early 1980s a rising gold price was seen by some analysts as a leading indicator of future inflationary pressures. Now, there are very few who would subscribe to this view and the strong gold price seems to be due to increased demand from investors wishing to diversify away from equity markets in uncertain times.
Lower interest rates, a declining dollar exchange rate and rising commodity prices are likely to be a feature of the financial landscape for most of 2003.
Slow global economic growth and very low global inflation combined with so much uncertainty means that the balance of probability points to 2003 being another very difficult year for investors.
