Stormy 2004 makes way for challenging 2005
2004 has ended and, while some forecasts made at the beginning of the year went according to script, as usual, the year had its fair share of surprises for markets. Pundits will, no doubt, be looking forward to the new year with new forecasts in a very challenging environment for market predictions.
Arguably, the most unexpected event of the year came on 26 December, when an earthquake registering 9.0 on the Richter scale hit the Indian Ocean floor off the west coast of the Indonesian island of Sumatra. The earthquake triggered a tsunami that has taken -- as far as is known at the time of writing -- over 140,000 lives. As some commentators have described, it is a disaster of truly biblical proportions.
Those countries directly hit by the earthquake and tsunami -- Indonesia, Sri Lanka, India and Thailand -- will have to bear the cost of reconstruction, which is likely to stretch beyond 2005. Their travel-related industries -- the airlines and tourism -- is also likely to be affected. Insurance companies will also be hit, but for insurers, the hurricanes and typhoons that hit the United States and other parts of the world earlier in the year probably had greater impact.
Compared to this cataclysm, everything else that happened in 2004 seems relatively mild.
There were plenty of elections in 2004. President George Bush was re-elected to the US presidency. A few countries saw changes in leadership, including India and Indonesia.
Stock markets around the world did well, with most major markets ending well into positive territory. In this regard, there was little surprise: stock markets generally do well in the year of a US presidential election.
Bonds, however, behaved contrary to expectations. At the beginning of the year, most analysts had expected interest rates to rise. The US Federal Reserve obliged by raising the target federal funds rate, but the yield on 10-year Treasuries finished the year at 4.22 percent, down from 4.25 percent at the end of 2003. The difference in yield between the 10-year and two-year Treasuries is 115 basis points, compared with 242 basis points at the start of the year.
One of the reasons for the stubbornly low long-term bond yields was Asian central bank buying. Determined to maintain the competitiveness of their economies through weak currencies, many Asian central banks, notably Japan and China, have been buying US dollars, which are then recycled into US bonds. This persistent buying has helped keep long-term bond yields low.
Despite Asian central bank buying, however, the US dollar fell against the yen and the euro for the third year in a row in 2004. The US currency fell 7.1 percent versus the euro and 4.3 percent against the yen as the US current account deficit ballooned to new records, hitting US$164.7 billion in the third quarter of 2004, 5.6 percent of US gross domestic product.
Commodities rose in 2004, fueled by surging demand from China. Gold rose in tandem with the fall in the US dollar. However, it was oil that stole the show. Crude oil prices rose 34 percent through the year, with Brent crude for February settlement closing at US$40.46 a barrel and NYMEX light sweet crude closing at US$43.45 a barrel after hitting a record US$55.67 in October.
So what will 2005 bring?
Analysts are generally sanguine about equities in 2005. The US stock market is expected to show a small gain. Europe and, especially, Asia are expected to perform better on better valuations. But how equities perform will depend on how the economy and other markets perform.
Interest rates are generally expected to rise in 2005. Of course, that was also what analysts expected in 2004. Nothing can be guaranteed. Indeed, inflation, one of the key drivers for interest rates, was generally below expectations in 2004, despite the surge in oil prices. Some analysts are expecting another surprise on the downside for inflation and long-term bond yields in 2005. A flattening of the yield curve -- a reduction in the difference between long-term and short-term yields -- may be a bad sign for equities.
Interest rates in Europe and Asia especially may be capped if anticipation of further weakness in the US dollar drives capital into these markets. Most economists acknowledge that to reduce the current account deficit, the US dollar needs to fall further, especially if the Bush administration fails to curb the other US deficit, its budget deficit.
Oil is expected to fall in 2005, with both Brent and NYMEX crude oil expected to average below US$40 a barrel. Much will depend, though, on whether China's demand for oil moderates and by how much. 2004 saw the Chinese economy moderate, albeit slightly. If it continues to moderate, or worse, suffer a hard landing, oil prices -- indeed prices for many commodities -- may see significant falls.
Finally, the performance of all of these markets will depend on the performance of the world economy. Most economists see a moderation in economic growth in 2005, but no recession. An increasingly indebted US consumer -- the engine of global growth for the past few years -- will have to curb his spending and rebuild his savings, but an outright collapse in US consumer spending is not expected.
A slowdown in spending by US consumers will have to be made up with spending from other sources. US corporations are relatively cash-rich and many analysts expect to see this cash make its way into the economy, either through corporate investment or by having it returned to investors. Other potential sources of increased demand include Europe and Asia, especially if rising currencies boost consumer spending.
However, it is far from certain that these sources of demand will manifest themselves in 2005. Should the highly-indebted US consumer start cutting back on spending but these alternative sources of demand growth fail to materialise as hoped, the expected moderation in economic growth may yet be turned into an outright recession.
Yes, I think forecasting for 2005 will be very challenging indeed.
Arguably, the most unexpected event of the year came on 26 December, when an earthquake registering 9.0 on the Richter scale hit the Indian Ocean floor off the west coast of the Indonesian island of Sumatra. The earthquake triggered a tsunami that has taken -- as far as is known at the time of writing -- over 140,000 lives. As some commentators have described, it is a disaster of truly biblical proportions.
Those countries directly hit by the earthquake and tsunami -- Indonesia, Sri Lanka, India and Thailand -- will have to bear the cost of reconstruction, which is likely to stretch beyond 2005. Their travel-related industries -- the airlines and tourism -- is also likely to be affected. Insurance companies will also be hit, but for insurers, the hurricanes and typhoons that hit the United States and other parts of the world earlier in the year probably had greater impact.
Compared to this cataclysm, everything else that happened in 2004 seems relatively mild.
There were plenty of elections in 2004. President George Bush was re-elected to the US presidency. A few countries saw changes in leadership, including India and Indonesia.
Stock markets around the world did well, with most major markets ending well into positive territory. In this regard, there was little surprise: stock markets generally do well in the year of a US presidential election.
| Start of 2004 | End of 2004 | Percent change | |
| S&P 500 | 1,111.92 | 1,211.92 | 9.0 |
| Nikkei 225 | 10,676.64 | 11,488.76 | 7.6 |
| Hang Seng | 12,575.94 | 14,230.14 | 13.2 |
| Straits Times | 1,764.52 | 2,066.14 | 17.1 |
| FTSE 100 | 4,476.9 | 4,814.3 | 7.5 |
| DAX | 3,965.16 | 4,256.08 | 7.3 |
| CAC 40 | 3,557.9 | 3,821.16 | 7.4 |
Bonds, however, behaved contrary to expectations. At the beginning of the year, most analysts had expected interest rates to rise. The US Federal Reserve obliged by raising the target federal funds rate, but the yield on 10-year Treasuries finished the year at 4.22 percent, down from 4.25 percent at the end of 2003. The difference in yield between the 10-year and two-year Treasuries is 115 basis points, compared with 242 basis points at the start of the year.
One of the reasons for the stubbornly low long-term bond yields was Asian central bank buying. Determined to maintain the competitiveness of their economies through weak currencies, many Asian central banks, notably Japan and China, have been buying US dollars, which are then recycled into US bonds. This persistent buying has helped keep long-term bond yields low.
Despite Asian central bank buying, however, the US dollar fell against the yen and the euro for the third year in a row in 2004. The US currency fell 7.1 percent versus the euro and 4.3 percent against the yen as the US current account deficit ballooned to new records, hitting US$164.7 billion in the third quarter of 2004, 5.6 percent of US gross domestic product.
Commodities rose in 2004, fueled by surging demand from China. Gold rose in tandem with the fall in the US dollar. However, it was oil that stole the show. Crude oil prices rose 34 percent through the year, with Brent crude for February settlement closing at US$40.46 a barrel and NYMEX light sweet crude closing at US$43.45 a barrel after hitting a record US$55.67 in October.
So what will 2005 bring?
Analysts are generally sanguine about equities in 2005. The US stock market is expected to show a small gain. Europe and, especially, Asia are expected to perform better on better valuations. But how equities perform will depend on how the economy and other markets perform.
Interest rates are generally expected to rise in 2005. Of course, that was also what analysts expected in 2004. Nothing can be guaranteed. Indeed, inflation, one of the key drivers for interest rates, was generally below expectations in 2004, despite the surge in oil prices. Some analysts are expecting another surprise on the downside for inflation and long-term bond yields in 2005. A flattening of the yield curve -- a reduction in the difference between long-term and short-term yields -- may be a bad sign for equities.
Interest rates in Europe and Asia especially may be capped if anticipation of further weakness in the US dollar drives capital into these markets. Most economists acknowledge that to reduce the current account deficit, the US dollar needs to fall further, especially if the Bush administration fails to curb the other US deficit, its budget deficit.
Oil is expected to fall in 2005, with both Brent and NYMEX crude oil expected to average below US$40 a barrel. Much will depend, though, on whether China's demand for oil moderates and by how much. 2004 saw the Chinese economy moderate, albeit slightly. If it continues to moderate, or worse, suffer a hard landing, oil prices -- indeed prices for many commodities -- may see significant falls.
Finally, the performance of all of these markets will depend on the performance of the world economy. Most economists see a moderation in economic growth in 2005, but no recession. An increasingly indebted US consumer -- the engine of global growth for the past few years -- will have to curb his spending and rebuild his savings, but an outright collapse in US consumer spending is not expected.
A slowdown in spending by US consumers will have to be made up with spending from other sources. US corporations are relatively cash-rich and many analysts expect to see this cash make its way into the economy, either through corporate investment or by having it returned to investors. Other potential sources of increased demand include Europe and Asia, especially if rising currencies boost consumer spending.
However, it is far from certain that these sources of demand will manifest themselves in 2005. Should the highly-indebted US consumer start cutting back on spending but these alternative sources of demand growth fail to materialise as hoped, the expected moderation in economic growth may yet be turned into an outright recession.
Yes, I think forecasting for 2005 will be very challenging indeed.
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