A number of outcomes are possible in the equity market, says Andrew Hunter Johnston.
The equity outlook depends on the usual suspects - economic growth, company profits, interest rates, inflation, currencies - which are finely balanced at present, making predictions hazardous. Our key assumption is that the dollar will stabilise. From this starting point we have identified some possible surprises in 2005. Some are probable, some unlikely - all would have major consequences.
First, the good scenarios - such as a US corporate profits surprise.
Profits growth of more than 10 per cent would exceed expectations, driven by productivity improvements and the weak dollar. This is quite possible for non-financial companies.
Merger and acquisition activity may boom. Strong company cash flows, low funding costs and reluctance to invest in fixed assets suggests this is likely and would be positive for equities, especially if cash is returned to shareholders.
Oil prices could plunge. A fall resulting from reduced geopolitical risk would be very different from a demand slump. Our view is that a 'good' decline seems unlikely but not impossible.
World economic growth will stabilise at 3 per cent. We think this outcome is the most likely, assuming no shocks from the cost of oil, the housing market or unemployment.
Interest rate pressures
And now for some of the bad scenarios. Inflation could rise, but we think this is unlikely. Interest rate rises could put pressure on share prices.
The rate cycle has turned, and in the absence of an inflation shock (which we consider unlikely) we do not see a risk of significant rate rises.
Volatility could rise. We see some reasons to fear increased equity volatility - lower profits, for instance - but the greatest risk of a spike remains in currencies.
Finally, the worst-case scenarios. Bonds could outperform equities as economic growth implodes. This would be the most potent surprise for 2005, particularly if unprompted by any major geopolitical event. While we see a collapse as unlikely, we cannot rule it out.
Oil moves towards $60, Iraq continues to drain US cash, and Al-Qaeda attacks the Saudi oil infrastructure. These events are easy to imagine and impossible to forecast. The impact on markets would be severe.
In summary, we foresee economic growth stabilising; a profits surprise on the upside for non-financial companies, and disappointment for financials; the dollar recovers or stabilises against the euro; inflation remains benign and interest rates rise only slowly, if at all. In such a scenario, dividends will supply a significant proportion of a 5-8 per cent total return for equities.
- Andrew Hunter Johnston is head of charities at Merrill Lynch Investment Managers