World markets set for a year of optimism

... but will early hopes for stable growth in the US and Europe be dashed by inflation or recession? Diane Coyle reports

At the start of 1995 many strategists were gloomy about the prospects for world stock and bond markets. They were cheered up enormously by the course of subsequent events. Could 1996 be the year in which the reverse happens?

There is certainly a high degree of agreement - a suspicious sign to some - that the general economic and financial environment is benign. Inflation has been conquered. Growth in the industrial world has slowed to a sustainable pace and, if it is currently a bit too weak, is likely to pick up again in 1996.

In fact, the financial markets are betting heavily that they will get the best of all possible worlds. Dealers expect that, thanks to the slowdown and disinflation, interest rates will fall again in Europe and the US. In Japan, where rates are at historic lows, the central bank will continue to inject liquidity into the banking system.

Most experts would see the biggest risk as even slower growth or outright recession. Giles Keating at CS First Boston says: ``The US slowdown is probably not serious but Europe looks extremely weak. We have got to see more in the way of interest rate cuts.''

Michael Hughes, head of strategy at BZW, believes that the world economy will begin to react to the past and future interest rate reductions. "[The year] 1995 was [when] governments woke up to the deflationary tendencies," he says. "In 1996 we should expect the response. He adds: ``My emphasis is on growth.''

The task for investors is pinpointing where the best growth will occur. Mr Hughes figures that corporate investment will at last expand, that commodities will benefit from renewed growth, and that the Asian consumer boom will continue.

If this scenario turns out to be too optimistic, it will not necessarily alarm bond investors, although recession would threaten share prices through its impact on corporate profits. However, some analysts take a more apocalyptic view about the risks arising from a downturn in the world economy.

John Lipsky, chief economist at Salomon Brothers in New York, argues that recession would put the consensus on market-friendly economic policies at risk. Most governments agree that they need to cut budget deficits, bring interest rates down, and continue to deregulate their economies.

Longer-term problems such as the scale of unfunded state pension liabilities in any countries will keep up the pressure to reduce current budget deficits. For example, these liabilities range from 43 per cent of GDP in the US to an awesome 233 per cent in Italy and 250 per cent in Canada. But if a slowdown in the near term started to make voters disgruntled, policy- makers might be tempted to reflate.

Stephen Roach, New York economist at investment bank Morgan Stanley, puts it in more apocalyptic terms. Policy austerity could cause a backlash, he reckons. ``Look no further than the streets of France for a prototype of how this response might play out elsewhere in the industrial world.''

A subsidiary and widespread fear is that the Maastricht process of deficit reduction will bring more currency turmoil in Europe. Few analysts have any confidence that progress towards the single currency will be smooth in the run-up to next year's inter-governmental conference. ``If there is any sort of negative surprise on growth in Europe, policy could easily become destabilising,'' said Paul Mortimer-Lee, chief economist at Paribas.

However, if the worst fears of the financial market prove unfounded, the chances are that governments will continue with their current policies of tighter fiscal policy and cautious relaxation of monetary policy. The growth of corporate earnings in the US and Europe is likely to be lower in 1996, but a continued rally in the bond market should keep share prices on the increase.

Wall Street has been taking a lead in reacting to bonds. Apart from the surge in technology stocks, it is the fall in the benchmark long-term Treasury bond yield to its current level of just under 6.1 per cent - the lowest in nearly two years - that has driven the rise and rise of the Dow Jones index.

Mark Brown, chief equity strategist at Hoare Govett, said: ``Wall Street is extremely vulnerable to any correction in bonds.'' Other guides - the p/e ratio, the dividend yield and cash flow - currently give mixed signals, he argues.

The 100-point fall in the Dow on the Monday before Christmas, in the biggest one-day drop for more than four years, was a dramatic illustration of that vulnerability. With the same link to bond performance holding for other world stockmarkets, they followed the Wall Street lead.

Pessimists about inflation are few and far between at the moment. However, any inflation news that is worse than expected could reduce the room for further interest rate cuts. As these have been priced into bond yields, a change of heart in the markets part-way through the coming year would certainly bring high drama.