Outlook: Look to Japan for best value in unpredictable stock markets

For crystal-ball gazers, this year has proved one of the most predictable in ages for economic and stock market developments. Two features dominated the early part of the year. One was the geo-political tensions caused by the build-up to the Iraq war; the other was the fear of deflation. As a consequence, the early months saw economic growth grind to a halt, equities plumbing new depths, and bond yields testing new lows. Equally easy to see was that once the uncertainty of war had been removed, then things would bounce quite substantially.

For crystal-ball gazers, this year has proved one of the most predictable in ages for economic and stock market developments. Two features dominated the early part of the year. One was the geo-political tensions caused by the build-up to the Iraq war; the other was the fear of deflation. As a consequence, the early months saw economic growth grind to a halt, equities plumbing new depths, and bond yields testing new lows. Equally easy to see was that once the uncertainty of war had been removed, then things would bounce quite substantially.

I therefore count myself among the many in broadly being right in my forecasts for this year. On stock markets, I said that after early weakness, the FTSE 100 would rebound to end the year a bit higher. In the event, the London market looks like finishing some 13 per cent up on the year. On the economy, I saw the best growth coming from the US, Europe still sluggish, and Britain somewhere in the middle, though still below what the Chancellor was then forecasting of 2.5 to 3 per cent. The latest estimate is for growth of 2.1 per cent. According to OECD forecasts, the US will record 2.9 per cent and the eurozone 0.5 per cent.

The key ingredient in the rebound was that the war went roughly as planned. OK, so no weapons of mass destruction were found, but in military terms, the Iraq war has to count as one of the most successful invasions of all time, with the official campaign lasting less than three weeks.

The ongoing cost in terms of continued loss of life and extended military deployment might seem high, but it is not nearly as bad as the doomsters had predicted and relative to some past conflicts, such as Vietnam, it is tiny. Perhaps predictably, the risks were overestimated by the capital markets, providing one of the best stock market buying opportunities of the past 50 years. That opportunity was made the better still by forced selling from the big life assurers. The solvency rules worked as they were supposed to in insuring than no substantial life assurer went bust, but they also helped drive European equities down to ridiculously low levels.

One of the stock market curiosities of the past year was that even as the rebound in equities gathered pace, bond prices continued to rise in tandem, driving bond yields to record lows. At that stage in the cycle, equities and bonds would normally move in opposite directions. Equities were rising in anticipation of a sharp economic rebound. Bonds were rising in anticipation of ever lower interest rates to combat the risk of deflation.

Plainly, they couldn't both be right. In the end, the recovery story gained the upper hand. The fact that markets got it so badly wrong on bonds is largely down to the US Federal Reserve, which made a series of scaremongering remarks about the threat of deflation, and then failed to follow through with the policy action it suggested might be necessary to address it.

In any case, the rise in bond yields since then has in some respects been even more dramatic than the rebound in equity markets. For instance, the yield on 10-year Japanese Government Bonds has nearly doubled since April. All that has really happened is that bonds, like equities, have returned to what might be deemed fair value. The anomalies that occurred around the time of the Iraq war have been corrected. Easy to see with the benefit of hindsight, isn't it? Perhaps not so easy in the blind panic that ruled in the run up to the war.

A stock market ruled by geo-political uncertainty is none the less easier to read than one dominated only by the often arbitrary ebb and flow of capital allocation, which is what we've got at the moment. The low-hanging gains in equity prices have already been plucked. The bet on stock markets becomes more high risk from here on in.

Only one thing seems certain. Interest rates the world over will remain subdued for much of the coming year. After a recent visit to Japan, I can confirm that there is a real determination among policy makers at the Bank of Japan and the Ministry of Finance to hold short-term interest rates at zero for as long as it takes to exorcise deflation from the Japanese economy. Japanese policy makers do not intend to repeat past mistakes by tightening too soon. As a result, I would suggest that the zero interest rate policy will be maintained long beyond what the markets expect.

With the US presidential election looming, the policy mix remains extraordinarily relaxed in the US too. As for Europe, the ever strengthening euro must surely make the European Central Bank eventually see sense and cut rates. Only in Britain among the world's leading economies is there any likelihood of a significant tightening, and even here few are betting on any more than a modest rise, taking base rate to a maximum by the end of next year of, say, 4.5 per cent.

The biggest danger to the general health of stock markets none the less remains the US, where to the outside world it appears that caution has been thrown to the winds in an effort to ensure President George Bush gets a second term. Since he's only allowed two, he's not so bothered about what happens after he wins.

Both fiscal and monetary policy in the US are therefore almost certainly too loose. After the elections, there will be a price to pay in higher inflation, higher rates and lower growth. America's still growing current account deficit makes the economy more vulnerable still. Long gone are the days when the deficit would be funded by vast inflows of international capital, keen to get a cut of America's high growth, hi-tech story.

Today, the dollar relies instead on funny money from the Far East to prevent free fall. The printing presses of Japan and China are being kept on overdrive to produce the money the US needs to borrow to keep buying the Far East's exports. That's plainly unsustainable, yet the unsustainable can go on an awfully long time before becoming unsustained. All the same, eventually something must give. If Japan and China stop lending, the dollar would collapse and interest rates would rise sharply. The resulting demand shock to the US and world economies might be considerable.

Of course, things don't have to end badly, and most of the time calamity is avoided. The relationship between America on the one hand, with its huge trade deficit, and Japan and China on the other, with their surpluses, is a symbiotic one which both sides are desperate to maintain.

That it might all unravel is none the less the big worry that will overhang stock markets next year. As for the FTSE 100, don't expect fireworks. This year's 13 per cent rise looks good by the standards of the previous three years, but it is not among the best performers internationally. The FTSE 100 has lagged other European stock markets throughout this year.

Reasons are not hard to identify. Our economic resilience is largely based on consumption and debt, storing up potential problems for the future, our productivity growth is still lamentably poor compared with the US and large parts of Europe, and our corporations have not restructured as aggressively as those of the US and Japan.

As a recent circular from Lehman Brothers points out, some 30 per cent of the UK stock market by value is in some way connected with the housing market - through lending, construction or household goods - an area of the economy which is almost certainly past its high water mark.

The best value in equity markets for next year therefore lies not in Britain or the US, but in the Far East, and in particular, South Korea and Japan, both of which are being galvanised into higher levels of efficiency and innovation by rapid development in China.

Japan is committed to massive tax breaks to industry for research and development in its determination to find the next "big thing" in product innovation. This is not a strategy that will pay early dividends, and there are still big structural problems that Japan must confront before the economy can be taken off the critical list. But given the alternatives....

jeremy.warner@independent.co.uk