Stock markets performed spectacularly in 2006, continuing a bull run that has now lasted about four years. Despite an ongoing slowdown in the US economy, the global economy is likely to stay relatively healthy in 2007. However, further gains in stock prices are far from assured.
For stock markets, 2006's performance is hard to beat as it is. It was a year that saw many market indices, including the Dow Jones Industrial Average, make all-time highs. The following are the performances of the major stock markets according to their respective Morgan Stanley Capital International indices:
Gains were even bigger in emerging markets, including the so-called BRIC.
All these gains were achieved despite a clear slowdown in the US economy, the global growth engine. US real GDP growth slowed from a 5.6-percent annual rate in the first quarter of 2006 to 2.6 percent in the second quarter and 2.0 percent in the third.
Persistently low interest rates helped stocks, especially in a financial world that is seeing increasing use of financial derivatives and leverage. Despite higher official rates from all the major central banks, longer-term bond yields stayed relatively steady. For example, the US 10-year Treasury yield, which started the year at around 4.4 percent, finished the year at around 4.7 percent despite the federal funds rate rising one full percentage point over that period.
In addition, some central banks have hardly moved interest rates up. The Bank of Japan ended its "quantitative easing" policy in March, raised its overnight call rate target to 0.25 percent from zero in July, then did nothing else for the rest of the year.
However, through most of the first half of the year or so, while the Bank of Japan and other central banks were still actively tightening monetary policy, bonds weakened and yields went up as inflation fears rose and investors became increasingly convinced that central banks were bent on beating it. That caused stock markets worldwide to tumble in May and June.
But around the middle of the year, markets began to perceive that inflation had peaked or was about to peak, a perception that was reinforced by the Federal Reserve going into pause mode from August onwards. Bond yields then started to decline. And stock markets took off.
So what are the prospects for 2007?
The consensus among economists appears to be for a soft landing for the US economy and a gradual decline in growth rates for the rest of the global economy. This view is supported by signs of a stabilisation in the US housing market as well as continued gains in various indices of leading indicators for the global economy. At the same time, inflation appears to have peaked in the US and, once slower growth takes hold, is widely expected to slow in the other economies as well.
With such an outlook, the Federal Reserve is widely expected to cut rates, possibly as early as the first quarter of the year, although most of the other major central banks are still expected to continue raising rates, at least in the early part of the year, until slower growth and inflation becomes more apparent.
So the overall economic environment is expected to be benign: Slow growth but accompanied by low interest rates. Such an environment is usually considered good for stocks.
And yet, with stock markets having risen as much as they have in 2006, there is a real possibility that stock investors have already discounted the benign economic environment. Most market forecasters see higher stock prices for 2007 while sentiment indicators also show that investors are generally bullish going into the end of 2006, a picture supported by low implied volatilities for stocks and low spreads in credit markets.
Such bullishness could mean that stocks are currently -- in the words of some analysts -- already "priced for perfection", leaving no room for positive surprises, only negative ones.
For example, if the economy turns out to be weaker than expected, investors are likely to become concerned about earnings growth and sell stocks. A recession could turn what is currently expected to be a mere slowing of corporate earnings growth into outright earnings decline and pull stock prices down as well.
On the other hand, if the economy proves unexpectedly resilient, investors are likely to become concerned that inflation could persist and interest rates could rise, and sell stocks anyway. Indeed, as of today, all of the world's most important central banks -- the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England -- maintain at least a bias towards higher rates; none have expressed an inclination to cut rates soon. This is in direct contrast with the view of many analysts that at least the Federal Reserve is poised to cut rates.
Stocks that are priced for perfection are also vulnerable to financial shocks -- including those arising from natural disasters and geopolitical events -- especially with the widespread use of leveraged financial instruments.
To sum up, we probably have a benign global economic environment ahead of us which would provide investors in the stock market with more gains over the next year or so. But having finished 2006 on a canter, stock market bulls will have to enter 2007 walking on a tightrope.