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International equities had another bad year in 2002, falling for the third year in a row and losing 23.8 per cent. This reflected weak profit growth, the continuing fallout from the bursting of the technology bubble and increased investor risk aversion, reflecting economic uncertainty, corporate scandals in the US and geopolitical risks. Unsurprisingly, global bonds had another good year, consistent with deflation fears, downward revisions to interest rate forecasts and a flight to safety by investors.

We see several main themes:

•The below-par global recovery is likely to continue. Most leading indicators are still consistent with modest growth ahead and some are suggesting that the US will be starting to emerge from a soft spot around August-October. If the US consumer can keep going (and they are being helped by reasonable real wages growth, big savings on their mortgages and likely further tax cuts), the US economy should pull through. Japan and Europe should follow suit.

•Core inflation rates are likely to edge lower. Global growth is likely to remain below potential and excess capacity will only gradually be used up. As a result, the fear of deflation may persist for a while to come.

•Interest rates are likely to be benign for the afore-mentioned reasons. Further rate cuts are likely in Europe and the US Federal Reserve is likely to be on hold for some time.

•Geopolitical tensions/fear of terrorist attacks are likely to remain a major factor. The US appears to be edging closer to war with Iraq. If this occurs, it should hopefully be over quickly. However, the uncertainty will be negative for consumer, business and investor confidence and may constrain share markets in the very short term. Beyond this, though, are the potential longer-term consequences of such a war, and in any case the threat from Al Qaeda still exists.

Implications for asset markets

With global growth likely to continue to recover, interest rates remaining low and shares still cheap versus bonds, we see equities outperforming bonds throughout the rest 2003.

Nevertheless, there is still much that could go wrong in the year ahead. We see four main risks. First, any war with Iraq could go wrong, with weapons of mass destruction being deployed or further terrorist attacks occurring. In addition, the current period of uncertainty regarding Iraq could continue for while, keeping oil prices high and constraining business and consumer confidence.

Second, weak US profit margins could prompt another bout of corporate cost-cutting.

Third, US consumers could lose confidence and cut back spending.

Fourth, the blow to investor confidence from the last three years of falls in global markets could prove difficult to overcome and investors may simply continue to take their money away from shares.

On balance, we believe that global equities have the potential to return 10-15 per cent in 2003 although it could be a bumpy ride, especially in the short term.

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