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Investment View: Good outlook but be realistic

You can tell we are approaching the end of the year by the number of forecasts in the financial press from pundits trying to peer into the murky months ahead.

Overall, 2005 has not been a bad year for investors. Equity investors are likely to see positive returns for the third year running and bond markets have not treated us too badly either. But how many were forecasting a year ago that Japan would be the developed market of choice for investors?

The research team at Barclays Investment Services did and their view that Japan had turned the corner and would reward equity investors has come home in spades. They could not have foreseen, of course, the general election that endorsed Koizumi’s position and gave impetus to his reform programme. Nor, I suspect, did they expect quite the recovery that has taken place.

But what are the themes to look out for in 2006? Among the expectations that should have a positive influence on equities is the continuation of the merger and acquisition boom, further rises in raw material prices and rising spending on information technology. Of course, there are risks as well.

Some believe a return to a period when markets are more volatile could be around the corner. Investors have indeed been fortunate in experiencing decreasing volatility in recent years. For example, US equities have not lost or gained more than 2 per cent in any one day in the past 12 months, whereas in 2002 there were 53 such occasions. I believe we should be prepared greater volatility.

I have also been struck by concerns over rising inflation and loss of momentum in emerging markets. The latter has been particularly rewarding for investors recently, with the MSCI Emerging Markets index up by more than a fifth to December. With political risk re-emerging, and developed markets playing catch up, the fun, if not exactly over, may be somewhat muted.

On raw material prices, it is important to remember that not all commodity prices move in the same direction at the same time. Indeed, while oil has been weakening, the Barclays research team believes the balance between supply and demand in petroleum products remains sufficiently finely balanced for the bull case for energy to remain. Arguably, any diversified portfolio should include commodities and it looks as though oil will continue to occupy centre stage as far as markets are concerned.

The overall message is positive. Valuation levels and the relationship with bond markets look set to support the case for equities. Realistically, we should not expect any more than single-digit total returns. It is when the returns become unrealistic that investors need to take care.


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