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An unremarkable year

19 January 2005 Angelo Coppola

Peter Toogood, CIO of Forsyth Partners, United Kingdom, says that the good news was that equity markets ended the year at or near their 2004 highs.

Bonds did indeed confound the sceptics with the 10-year US Treasury Note unchanged on the year, but with European bonds actually making very positive gains.

Emerging markets rallied strongly and commodities in the broadest sense were very strong performers.

The bad news was that implementing these views was hellishly difficult. Active managers have finished the year well but many have struggled against benchmarks in most of the major markets over the full twelve months.

I have personally never seen such an array of managers, in so many different markets, struggle to compete with the indices. The task is clearly made more difficult by the fact that most of the major indices ended the year as top quartile performers.

In such an environment a fund of fund manger is left to play the mug's game of 'guess who performs' in the short-term? Do you sell Legg Mason's Bill Miller when he is 7% behind the benchmark in the 3rd quarter of 2004?

Well no, because by the end of the year he managed to outperform the benchmark. As we have said on numerous occasions if there is no persistence in performance, then our research would be invalid and our investment process redundant. In summary, we would describe the year as profitable but frustrating.

The year ahead

In many ways we see most of the themes from last year persisting into 2005.

The big picture decision is whether there will be an end to the reflation trade. This trade ceases when negative interest rates turn positive, with money supply growth slowing rapidly as a result.

Currently all financial assets are being bid higher based on this simple premise, but any inflation scare is likely to send asset prices reeling. The moment money supply looks tight people tend to head for the exit.

We saw a vivid demonstration of what the end to the trade could look like for a brief period in 2004 and we will undoubtedly see another inflation scare in 2005 (possibly in the first quarter).

It may not be quite so unpleasant, as there is now less leverage being applied, but it will still convince the ardent bears that the end of the world is nigh at the same time as discouraging the bulls from investing!

We are sticking with the view that global growth in 2005 will be on a weakening trend from 2004's furious pace and believe that central bankers will need to respond accordingly by toning down their tightening rhetoric.

If this policy response is forthcoming we would not be surprised to see co-ordinated global growth by this time next year. However, if the rhetoric persists it is the asset markets that will protest the loudest!

Strategic overview

In terms of equity strategy we are making the same assumption as in 2004. The markets will be volatile and sometimes look quite sickly. At the moment the balance of strategists expect a strong first half and a weaker second half.

However, we plump for the theory that the first half will see markets climb a wall of worry and occasionally fail but the second half will look better overall. In 2004 you needed to invest for the whole twelve months as returns were lumpy. Again, trying to trade around these returns will be futile and frustrating.

Style preferences

In terms of equity preference we see the usual desire for investors to switch to the laggards of last year by buying large over small and growth over value. Yet, there is no compelling reason for the positive trends in value, and to a lesser extent small caps, to end here.

If we are right that the reflation trade is still on in 2005, then value and small caps should continue to do well. However, this is a volatile strategy and there will clearly be periods of underperformance from holding the line.

Strategic preferences

The commodity bull story is clearly beginning to mature but we are still in favour of another run which could last up to 18 months based on superb supply demand dynamics.

Equally, emerging markets still compare favourably but will be more volatile as they are well owned globally. Europe as a region looks grey but its stock market must not be confused with its economy. It looks cheap on a relative basis and should do well after any growth wobble in 2005.

Japan is finally emerging from deflation and may do well in the second half of the year but is still very much China dependent. The US is dismissed as a basket case as usual, but 2005 looks like another year in which the US economy bears will be frustrated. The economy will not collapse and the stock market will not disintegrate.

An overly aggressive stance from the Federal Reserve will not help in the early going but we suspect they will relent as the year progresses.

Fixed income

From a fixed income perspective there is little to excite investors this year. Yields are well bid and gains will most likely be found in currencies not securities. It is hard to envisage high yield spreads compressing further and security selection will be a decisive factor this year.

The outlook for emerging bonds is also relatively benign.


The much maligned property sector is also likely to confound the more bearish commentators who seem convinced that a crash is imminent.

The reality is that property is a leveraged play on the individual and the corporation's ability and willingness to pay. In terms of ability to pay, one can cite low unemployment for individuals and strong balance sheets for corporations as a reflection of the ability to pay.

The willingness to pay stems from the cost of borrowing and here we see no imminent signs of significantly tighter money globally impacting property pricing. The globalisation process is also a genuine real wealth effect and regions like Asia will continue to see a positive effect expressed through hard assets like property.


The final quarter of 2004 was positive for alternative investments as they were able to place trades with more conviction.

The over use of leverage in 2004, which we highlighted as a key risk, looks to have been addressed and we expect the operating environment for hedge funds to be more constructive in 2005.

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