Jeremy Warner's Outlook: Who'd have thought it? Another good year for equities, but the fun is not entirely over yet

Predicting the future is a hazardous business, particularly when it comes to the economy and the capital markets. What seems obvious with the benefit of hindsight was generally not in the least bit predictable 12 months ago. It is only the mundane and unchanging that can be easily forecast. Yet it is the unexpected that tends to have the most far-reaching consequences, and by definition, few foresee the surprising.

Take, for instance, the movement of short-term UK interest rates. Fast back a year, and hardly anyone forecast that they would be lower now than they were back then. The expectation was instead for a steady tightening in policy, taking rates to perhaps as high as 5.5 per cent.

These expectations changed rapidly as the scale of the housing slowdown and fall off in consumption became apparent. The persistence of exceptionally high energy prices also took most forecasters by surprise. So the opinion formers changed their expectations to steadily falling interest rates. Eventually there was a cut, but the subsequent Inflation Report pointed to the possibility of tighter policy once the economic soft patch had been overcome. Hurried revision of forecasts. Since then, expectations have again been reversed, with most forecasters looking for some easing of interest rates early in the new year because of continued weakness in the economy. Our view of the future is constantly chopped and changed to reflect our experience of the present.

With these warnings in mind, it is with some apprehension that I come to review my predictions for 2005 and make some new ones for 2006. This time last year, I was accused by one reader of being less than clear cut in my forecasts, of hedging my bets, rather in the manner of the stockbroker who tells his client the stock market may go up, it may go down, but not necessarily in that order. So I'll try to be firmer in my predictions this time.

Only one of my forecasts turned out to be unambiguously correct, yet it was arguably also the most important one. My stock market of choice was Japan, which has been easily the strongest riser over the past 12 months among developed economies, with the Nikkei share index gaining an impressive 42.5 per cent, its best yearly increase since the mid-1980s.

I wouldn't pretend to be an expert on Japanese affairs, but perhaps strangely I've proved a better judge of the Tokyo stock market over the years than our own. Throughout the 1990s, I remained consistently bearish, only having reversed this view in the last couple of years.

There is good cause for this change of heart. After years of on-off recession and price deflation, greatly exaggerated by some appalling errors in macro-economic policy, Japan seems finally to be digging itself out of the economic mire. The re-election of Prime Minister Junichiro Koizumi has, meanwhile, underlined the country's commitment to structural and political reform. Despite ancient rivalries, Japan is also the biggest external beneficiary of China's economic miracle.

I was also right about the dollar, which despite the burgeoning twin deficits, I thought would strengthen against the pound and the euro in reaction to strong US growth and higher short-term interest rates. As for US equity markets, I predicted lacklustre growth, which again was broadly correct, though the strength of the dollar improves the look of the performance in sterling terms.

I was less far sighted when it came to other markets. After the boom year of 2004, I thought many emerging markets were riding for a fall. How wrong can you get? I also predicted lacklustre growth for the UK and Europe. In fact, the FTSE 100 is up nearly a fifth and the French and German markets by even more. My mistake here was in forgetting how much the UK market is geared to overseas earnings. Around half the FTSE's profits are earned overseas, with a particularly high weighting given over to the year's boom sectors and oil and mining.

In these circumstances, subdued UK economic growth hardly seemed to matter. Instead, investors were able to reap the rewards of higher energy and commodity prices, a renewed boom in takeover activity, buoyant corporate profits, and a veritable tidal wave of buy-backs and rising dividend payments.

My predictions for bond prices were also wide of the mark. These have failed to correct as anticipated, and indeed the recent inversion of the yield curve between short and long-term rates in the US may suggest the bull market in bonds has further to go. Yield curve inversions are seen by some market players as a prelude to recession, for they suggest that short-term rates have been raised too far, choking off demand, liquidity and inflation, and causing longer dated yields to fall in anticipation of a harsher economic climate to come.

Then again, the inversion may be no more than a technical reaction to burgeoning, demographically led demand for longer dated bonds. We'll see, but somehow I doubt the US economy is about to collapse into recession. This is one of those occasions where the crowd is probably right to predict at least another year or two of decent growth for both the US and world economies.

Heeding my reader's call for precision, I'll opt for 3 per cent growth in the US next year and go with the Treasury forecast of 2.25 per cent for the UK. In the US, the twin deficits remain a key concern, but for the time being the markets feel too comfortable to want to address them.

There's often little read through between economic and the stock market performance, so don't expect another year like the last for equities. Corporate earnings growth is slowing and by the end of next year, markets will indeed be starting to worry about the downturn. None the less, equities continue to look undervalued on historic measures. Despite a couple of good years, share prices have failed to keep pace with the rise in earnings.

I'm a bit more cautious on Japan than I was, if only because Tokyo has already had such a strong run, caused overwhelmingly by non-Japanese investors looking for Asian exposure. As Garry Evans, HSBC's Asian strategist, noted after a recent visit to the US, there are two views in America on Japan - bullish and very bullish. That feels dangerous to me. Markets may be getting a little ahead of themselves in anticipating rapid structural reform. Change is definitely in the air, but Japan remains a deeply conservative society, where reform proceeds at a glacial pace. Expect more pedestrian growth in the Nikkei next year.

Some of the same observations might be made about emerging markets, many of which have had a sensational run over the past two years. This is particularly the case in the Middle East, where many economies are experiencing boom conditions, despite the region's troubles. For the second year in succession, the Cairo and Dubai stock exchanges emerge as the top performers, having more than doubled in value in the past 12 months.

Again, that feels dangerous. Politically, socially and economically, many of these countries remain unstable. The risks of something similar to the Asian crisis of the mid to late-1990s - where banking systems, currencies, stock markets and economic growth collapsed - is plainly quite high, even if longer-term prospects continue to look outstanding.

So if not America, emerging markets, bonds or Japan, then where? It sounds counter-intuitive, I know, but the best value may now lie in sclerotic old Europe, and particularly London, whose stock market is in any case no longer representative of the British economy. Ever heard of Kazakhmys? Thought not, yet last month, this Kazakhstan copper mining play became a member of the FTSE 100. The London stock market is becoming more foreign than British, and as a relatively low risk bet on the continued progress of globalisation, looks as good value as anywhere.

j.warner@independent.co.uk