Apart from a nasty little wobble in May the past calendar year has been overall a satisfactory one for UK investors. The stock market has advanced by some 12 per cent, and even cautious depositors have been rewarded with a modest rise in interest rates from 4½ to 5 per cent.
Against expectations house price inflation has accelerated to nearly 10 per cent, while there is a real boom in the commercial property market which may show total returns of nearly 20 per cent for the year. Commodity prices soared in the early part of 2006 but have mostly subsided recently.
In fixed income, the returns on high quality bonds – such as gilt-edged – have remained unattractively low for private investors. As for corporate bonds, they have followed a rule which has applied across most asset classes this year: the riskier the better.
Can it continue? Year-end punditry tends to be dominated by self-interested practitioners and we should not be too impressed by the sayings of stockbrokers and fund managers. Apart from the odd Dr Doom, nobody seriously tries to forecast the next economic recession or equity bear market. And with UK equities having risen solidly for four years in a row, but not having yet recovered to the seven-year-old FTSE 100 Index peak, who is to say that the fifth year in the sequence, 2007, will be any different?
There is general agreement that the global economy will slow a little in the coming year. This will be mainly a problem for the US which is burdened by too much consumer debt and is already experiencing a house market price tumble. The OECD, for instance, is forecasting that US economic growth will slow from 3.3 to 2.4 per cent.
Most forecasters are expecting, nevertheless, that the boom in much of the rest of the world, led by countries such as China and India, will scarcely falter. In the UK, moreover, Gordon Brown, chancellor of the exchequer, earlier this month forecast that the economic growth rate would improve from 2.75 per cent in 2006 to 3 per cent in 2007.
Yet there are some flaws in this benign picture. Short-term interest rates are rising in the UK and the eurozone and inflation is stubbornly ahead of target: in the UK the old-style RPI (which includes mortgage interest costs) has shown a year-on-year rise of 3.9 per cent. Annual broad money growth has accelerated to an alarming 14 per cent which is probably a rather technical oddity, rather than a warning of future inflation, but the Bank of England is not entirely sure.
Meanwhile US rates will probably not go any higher than the 5 per cent which they reached back in June – forward interest rates in the money market do not anticipate such a rise anyway – but it all depends on whether a “soft” landing can be achieved. If growth fails to slow very much the US Federal Reserve will have to put interest rates up; if the US economy slumps, the stock market will be hit badly. Either way there is little room for error.
Financial regulators have their own worries about the rampant growth of credit and the derivatives markets. Private equity firms, and many acquisitive companies too, are borrowing heavily from banks to finance takeovers. A wave of defaults is starting to happen, involving for instance the big UK printing group Polestar earlier this month. While this kind of risk may not directly concern the average investor, there might be an abrupt end to the takeover boom, taking support away from the equity market.
When rival Indian and Brazilian companies are battling to acquire the Anglo-Dutch steel group Corus we can tell that these are very odd financial markets. The big picture is that the vast balance of payments deficit of the US – running at something like $900bn a year – is pumping enormous mirror-image surpluses into Asia, the Middle East and even parts of Latin America. The recycling of these flows, mainly into the debt markets, has squeezed the price of risk: too many assets, the bears worry, are “priced for perfection”.
If these flows tail away, either because the US goes into recession or the recipients, led by China, become reluctant to accept any more dollars, there will be severe economic and financial consequences. The benign forecasts for 2007 from mainstream forecasters therefore hide a dark side.
For the moment, though, all is well. Company profits, are very strong and earnings per share for UK-listed stocks are likely to achieve growth of around 12 per cent for the year. As for dividends and share buybacks, investors have been showered with cash, with dividends rising at double-digit rates for the second year running.
The big investment theme of 2006 for personal investors, however, has not been equities but commercial property funds. It seems as though this has been driven by advisers rather than investors themselves. Property offers diversification away from the risks of equities as well as, for the moment, high returns.
Can this continue? It depends on the achievement of strong economic growth in the UK and continental Europe, where the funds are mainly invested. There are increasing worries that property is turning into something of a bubble but the New Year launch of Reits, or listed investment trusts, will for the moment attract even more capital into the sector.
Meanwhile fixed-income investments remain dominated by the excess flows of global capital and also, especially at the ultra-long end, the search for liability-matching assets by pension funds and other financial institutions. Small investors are therefore rather priced out of the picture.
The consolation at present, though, is that deposit rates are relatively good. Staying liquid is a reasonable option until some of the inflationary clouds lift. Generally, equities appear reasonably priced but this does not rule out the chance that better buying opportunities will appear later in 2007.
