Market Matters Striding Forward Kevin Grice is a senior economist at American Express Bank's Global Economics Unit in London.   Capital spending in the USA, Europe, the UK, and Japan grew strongly in 2004 but the Euro-zone is still lagging behind. Meanwhile, corporate cashflow is healthy and many companies have used their cash holdings to reduce debt, increase dividends and to buy-back their own shares. We think business investment will stay strong and help sustain the global upswing in 2005-06. Firstly, US corporations have been forced to cut costs and boost profits. Having over-spent by the equivalent of 4% of US GDP in the late 1990s, the non-financial corporate sector generated surpluses in the last three years. With balance sheet repair largely over, corporates are now lifting investment and taking on more workers. In Japan, balance sheet repair started earlier, moving into financial surplus in the mid-1990s. It was also prolonged by cultural aversion to radical corporate restructuring, extensive cross shareholdings, as well as systemic banking sector weakness. Nevertheless, consumers have now become more positive and investment has picked up significantly since 2003. A second reason to expect strong investment is tight capacity use. Inventories, excluding the auto sector, are low in the US and Japan. This inventory overhang will stay a drag on Japanese investment growth, but it appears to be easing. In Europe, capacity use has stayed high but the sizeable output gap shows there is still slack in the system. This points to a more sluggish pick up in Europe. Thirdly, there is more confidence now that final demand will stay strong. The terrorist and security threat is not the drag it used to be on corporate and consumer risk taking. The 2004 rise in oil prices also lifted costs and threatened final demand. The expectation is that global growth will continue at a strong pace in 2005-06. Fourthly, real interest rates remain unusually low for this stage of the economic cycle. Productivity growth remains disappointing in the Euro-zone and in Germany, but this is encouraging investment in capital-intensive technologies and outsourcing to Emerging Europe. All of these upbeat factors also apply to Asia ex-Japan. In Asia, investment ex-China has been weak since the 1997 crisis. But low real interest rates, reduced political risks, improving business confidence, tightening capacity use and rising corporate profitability is now leading to stronger private investment. The two biggest risks to this upbeat view are that bond yields move up too much, or consumer spending slumps. We expect US bond yields to peak in the 5-5.5% pa range (for 10-year yields), not high enough to seriously threaten the investment upswing. Inflation should be controlled by subdued wage gains, the levelling out of commodity prices and some slowing in US GDP growth later this year. The biggest threat to US consumer spending is a crash in the housing market, but this is something investors should worry about for 2006-07. A consumer slump is more of a risk in Europe, but restructuring appears to have achieved a critical mass that is bringing more capital spending and should, eventually, bring more jobs and stronger domestic demand. For investors, the implication of continued good investment growth is that global equity markets should continue to outperform bonds. We would be cautious on equity markets until we know how much the Fed still has to do on interest rates. Stocks will rally when this becomes clear, and we expect non-US stocks to perform best over the next 12 months, especially Japanese and Asia ex-Japan equities.