Currency concerns cloud global horizon

Global economic growth is still above par, albeit decelerating somewhat from peak levels. Economic indicators are mixed in the US but are showing signs of improvement more recently. Similar indicators remain robust in Europe, Japan and emerging countries.

Labour markets and liquidity measures such as credit and money growth are strong in most countries. Inflation is reasonably contained, but capacity constraints point to medium-term inflation pressure and, hence, continued central bank vigilance.

Further monetary policy tightening is expected by central banks, hence the general trend is for interest rates to rise further.

The environment remains broadly supportive of the corporate sector and equity markets in general.

US dollar weakness is apparent and this is expected to continue as the US economic cycle diverges and as interest rate differentials widen in the face of relative US interest rate stability.

Outlook for global equities

We retain our positive outlook for the global equities sector for 2007 and our belief in a 9-10 per cent total return for global equities in 2007. Half of this return has already been seen in the period to May, so the markets are performing in line with this assessment.

In particular, global equities have risen 9.4 per cent so far in 2007 (for the period ending May 2007) in local currency terms.

However, the strength of the Australian dollar over this period has reduced the Australian dollar return (that is, the unhedged return) to 4.8 per cent. This figure is expected to rise to 9-10 per cent by the end of December 2007.

Australian currency appreciation has played a key role in the total return equation for international shares in recent years.

As an example, the Australian dollar has moved from around 50 cents to 84 cents recently, an 18-year high against its US counterpart. Australian dollar appreciation (that is, foreign currency depreciation) undermines global equities benchmark performance, although some of this can be recouped if Australian dollar hedging is permitted.

Further Australian dollar currency appreciation is anticipated (85-90 cents is plausible) as economic and interest rate differentials add to the commodity demand/price dynamic to be net supportive to the Australian dollar.

There are a number of factors that have been, and continue to be, supportive of global equities, including a positive 2007 first quater profit reporting period, a conducive macroeconomic environment, generalised balance sheet strength, favourable liquidity conditions, booming merger and acquisition activity and an elevated appetite for risk.

While market sentiment is largely bullish, this doesn’t mean shorter-term profit-taking corrections cannot take place. With valuations recently moving from cheap to fair for many markets, such corrections will prove inevitable, but this will also provide positioning opportunities.

Emerging markets are seen as offering better prospective returns than developed markets (15-20 per cent in 2007) given better earnings growth trends and relative valuations versus developed markets.

Interest rates are moving up and this has impacted on share market sentiment recently. But rates are moving up because economies are strong, hence our view that the fundamental backdrop for the corporate sector remains conducive for the balance of 2007.

Having said that, it is our expectation that economic growth and corporate earnings growth is in the process of normalising; that is, moving towards a sustainable pace that accords with a ‘soft landing’.

In the absence of any major discernable shocks on the horizon, it is difficult to see a hard landing scenario come about. The inflation dynamic will be critical to the evolution of the market environment in the second half of 2007.

How do global equities compare to domestic markets?

While return prospects are similar between global and Australian equities, further Australian dollar currency appreciation, if strong, would undermine global equities returns relative to the Australian market in the near term.

Nevertheless, over the medium term, we expect investor willingness to invest overseas will accelerate further as investors take up the wider investment opportunity set offered by international markets.

Specialist strategies, such as global emerging markets and global property securities, are already attracting greater attention.

Eric Siegloff is director, asset allocation and investment strategy at

ING Investment Management .