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Barclays Wealth global outlook 2007

Inflation pressures are still bubbling up, but the recent slide in oil prices has alleviated some of the concerns. Despite a major bout of the jitters in mid-year, most equity markets have recovered well. The key positives have been the huge level of available liquidity, attractive valuations and investors’ persistent willingness to take on risk. We have a sense that 2007 is going to be tougher. For one thing, interest rates are high – and likely to move higher still. Rates have already moved well above their emergency levels of 0% for Japan, 1% for the US and 2% for the eurozone. As we move through 2007, further increases in interest rates should start to weigh on households and investors, squeezing down global growth and moderating the potential returns from financial markets. In addition, economists’ forecasts for 2007 are much more divergent than in previous years. For example, forecasts for US short-term interest rates vary widely, from a cut to 4% to a rise to 6% (which is Barclays Capital’s view). Higher interest rates around the world and tighter credit conditions should bring the liquidity-fuelled frenzy in some asset classes to a halt. Wherever you look, house prices have risen, as investors have shied away from equities and used low interest rates to fund purchases of second homes and buy-to-lets. The recent collapse in the US housing market should serve to wake investors up to the risks from rising interest rates. Money has also been rolling into asset classes such as private equity and credit derivatives, where the degree of risk is not fully appreciated. Of course, our general call for a measure of caution doesn’t mean that investors should neglect the remaining opportunities, such as Japanese equities and undervalued commodity exposures, including the Oils sector. Nevertheless, it sends the message that investors should pay more attention to risk and to building some protection in to their investments. In particular, we would advise clients to ensure they have real diversification in their portfolios. Encouraged by easy money, some investors may have forgotten about the need to spread risk effectively. A cocktail of investments in metals, China-related equities and residential property has worked as an investment portfolio over the past couple of years. To our mind, however, many of the best-performing assets have performed well because of the extraordinarily abundant supply of liquidity. Take away easy money and these potentially highly correlated assets could all fall back together, just as they have all risen in synch. We would advocate a strategy that is built around good value, especially when tested against an environment of higher interest rates and slower growth. This underlines the need to focus on large-cap, higher-quality names in equities and to limit exposure to cyclical plays. Despite the better news on inflation, we see little value in bonds at these yield levels. Credit markets are equally uninspiring for those chasing capital returns. Where we do see potential are areas with solid revenue streams (such as infrastructure) or attractive income growth and yields (including European direct property).
Barclays Wealth has taken a look at some of the themes we identified at the end of 2005, how they played out over the course of 2006 and how we expect these to progress in 2007. Asset allocation
Our original view: In ‘Why equities?’, we argued that equities represented excellent value relative to bonds but that 2006 might turn out to be a year of consolidation, with comparatively modest returns overall.
Outcome: Equity markets made surprisingly good progress during the first four months of the year, before falling back sharply in May. Since then, equities have rallied strongly, with both the Dow and FTSE 250 hitting all-time highs.
Our updated view: Equity valuations, in absolute and relative terms, still do not look stretched, and we continue to support a modest overweight in equities relative to bonds and cash. We favour defensive sectors, which offer decent earnings fundamentals.
Our 2007 FTSE 100 year end target is 6800. Business spending: mergers and acquisitions (M&A)
Our original view: Healthy corporate balance sheets, cheap borrowing and the high level of free cash flow would continue to encourage M&A in 2006.
Outcome: Global M&A volumes were at a record level this year, comfortably surpassing the previous high of 2000.
Our updated view: We expect M&A activity to continue at its current high level in the first part of next year, before falling off as growth moderates later in the year. Business spending: IT
Our original view: We argued that Technology sub-sectors looked attractive when measured on earnings growth and valuation.
Outcome: The performance of the Technology sector has been disappointing this year. Corporate IT expenditure has not matched industrial capital expenditure, and there has been little M&A activity in the sector.
Our updated view: We still think the outlook for the sector is bright. Companies have been delaying expenditure until new products are introduced late this year and into 2007. The sector also looks attractive on valuation grounds after a year of underperformance. Inflation
Our original view: After remaining stable for over ten years, inflation looked set to become more volatile. We argued that inflation-linked bonds looked fair value relative to nominal bonds.
Outcome: Inflation has been a dominant influence this year. Core inflation in the US hit 2.9% in September – the highest level in over ten years. In the UK, inflation has been persistently above the Bank of England’s target rate since May.
Our updated view: We expect inflation to remain above the main central banks’ comfort zones for the first part of the year, but then to fall back as growth slows in the world’s big economies and the effects of higher interest rates start to be felt. Emerging-market equities
Our original view: After a period of strong performance, emerging markets faced several risks that we felt could weigh on returns in 2006. We recommended that investors take a more neutral position in the asset class.
Outcome: Emerging-market equities continued their strong run at the start of the year. Then, over the early summer, they suffered heavily amid investors’ concerns over the US economy and interest rates. Finally, towards the year end, investors regained their appetite for risk and emerging-market equities have rallied strongly. They are now up around 20% (in local currency terms) this year.
Our updated view: We maintain a relatively cautious view on the outlook for emerging-market equities, although the signal emanating from our Tactical Asset Allocation model has strengthened over recent months. It is now suggesting a neutral stance on emerging equities versus their developed peers. Commodities
Our original view: We argued that commodities’ good run still had further to go and that energy commodities in particular offered excellent diversification benefits.
Outcome: Commodities made good progress in the first half of the year. However, since then returns have been very volatile.
There has also been a divergence between the performances of different commodities.
Our updated view: We continue to recommend a long-term, strategic allocation to commodities. In the short term, we expect volatility to continue and so we are becoming more selective about how and when we invest in commodities. Volatility and correlations
Our original view: Volatility in asset markets fell dramatically in 2004 and 2005. We argued that cyclical and monetary factors could lead to a pick-up in volatility in 2006.
Outcome: After a reasonably volatile start to the year, markets become very volatile over the summer as a result of concerns about the US economy. However, as the year drew to a close, volatility fell back and is now at historically low levels.
Our updated view: We continue to expect higher volatility to be a feature of financial markets over coming months and years, as central banks around the world raise interest rates and companies increase their levels of debt in order to finance investment.
The Barclays Wealth Global Outlook 2007 consists of a number of essays focusing on: Equities – the nearly forgotten asset class
The Broadband Revolution
European Commercial Property
Infrastructure Investment
Yen to Strengthen
A Hard Landing in China
Credit Quality to Decline Further
Profits Collapse in 2007
Goldilocks and the Bulls
Hedge Funds