THE PAST FOUR YEARS HAS SEEN EVER-INCREASING volatility in global bond and equity markets and Arab private and official investors, notably the Abu Dhabi Investment Authority, the Kuwait Investment Authority, Qatar Investment Office and the Saudi Arabian Monetary Agency, have not been immune to market

On the contrary, the Middle East Gulf countries have more to gain or lose from fluctuation in stocks and bonds because the energy-rich region holds an estimated $1trillion or more in offshore assets, mostly in the US. But in the aftermath of the events of 9/11, there has been a gradual diversification of Arab portfolio investments into European markets--particularly the UK, France, Germany and Switzerland--with a view to potential capital growth and currency gains.

So far, the international capital markets have yielded uninspired performances amid rising US short-term rates, higher bond yields, soaring energy prices and slowing profit growth. Many cautious investors--hit by the 2001/02 dot.com recession--are still nervous of diverting sizeable cash reserves into stocks and corporate bonds. Consequently, the Standard & Poor's (S&P's) index of the leading 500 US corporates has failed to break through the 1,250 resistant level, reflecting weakening volumes and subdued investor confidence. Likewise, the technology sector--especially popular among Arab investors--continues to underperform the broader market, reflecting the Nasdaq index's inability to remain above the early 2005 highs of the 2,150 trading range. Market momentum warns of further declines or stagnation for high-tech stocks. Evidently, major private and institutional investors like pension/investment funds are sitting on the sidelines. But without a vast liquidity injection, stock markets will remain in a lacklustre mood.

Meanwhile, US government securities--Treasury bonds/notes--offer little investment value at current levels. Fixed-income assets usually underperform in times of rate hikes. Thus, Treasury prices drop when long-term bond yields are rising. The Federal Reserve Board (US central bank) will continue its 'measured' strategy of 25 basis points interest rate hikes, in the coming months. The futures markets expect key Fed Funds rate--the interest rate US banks charge on loans to one another--to reach 3.75%-4.0% by year-end or early 2006, from 2.75% currently. But larger than expected rate hikes, resulting from inflationary pressures or a marked reduction of foreign portfolio inflows into US Treasuries, could prompt violent market corrections, reviving memories of the October 1987 Wall Street crash.

However, such a scenario appears improbable under today's benign inflation climate and steady capital inflows from East Asia and China.

ORDERLY CORRECTION

The dollar-based Arab investors can take heart from the fact that the greenback's depreciation versus prime currencies (the euro, the yen and sterling) has been quite orderly, unlike the dollar-crises of 1985 and 1995. The much-feared turmoil in the euro/dollar exchange has not materialised. Fortunately for the six-member dollar-pegged Gulf Cooperation Council (GCC) countries, the euro/dollar exchange rate has remained stable since early 2005 at around $1.30, far below some bearish forecasts of $1.40-$1.45 to the euro. The fundamental reasons for the greenback's resilience despite yawning 'twin deficits' (federal budget and current-account) are increasing yield differentials versus Japan and the eurozone-bloc, firmer economic backdrop and productivity advantage over the eurozone.

J.P. Morgan Private Bank comments: "The dollar has fared better than expected so far, but we still expect it to weaken this year. So investors should not overstate their dollar assets." Prudential Financial, Inc. (US) also warned: "The dollar has derived support from rising US interest rates and a brief respite in the worsening of the US trade deficit but is likely to resume its deterioration later this year." Since the currency's technical indicators are looking weak over a 6-12 month period, a prudent strategy thus remains to hedge dollar exposures on rallies.

The dollar is slowly losing its allure as a global reserve currency that offers rock-solid returns and longer-term stability. A report compiled by Central Banking Publications and sponsored by the UK's Royal Bank of Scotland found that "central banks' enthusiasm for the dollar seem to be cooling off." Some 65 central banks took part and the findings showed a noticeable shift in sentiment among central bank reserve managers. In fact, 39 countries had raised their euro holdings, with 26 reducing dollar-denominated assets over the past two years. The majority of managers, controlling assets worth $1.7trillion, considered eurozone debt markets equally as attractive placement destinations as the United States.

In a further worrying trend for the US dollar, OPEC members have reduced the proportion of dollar-based deposits from three-quarters to three-fifths in the past three years.

According to the Bank for International Settlements--the "central bankers' central bank" in Basle--OPEC's gross deposits totalled $276.3bn as of September 2004. The top-five deposit holders were Saudi Arabia ($77,613m); the United Arab Emirates ($43,605m); Venezuela ($32,448m); Indonesia ($31,814m); and Kuwait ($24,896m).

ASSET ALLOCATION

There is a close correlation between the strength of global economic activity and relative bond and equity returns. When forward leading indicators in Europe, US and Japan fall over a 12-month period, bonds usually outperform equities and vice versa. Hence, the prospects of economic weakness or even an outright recession are, in fact, good news for long-term bond investors but negative for stock prices.

Traditionally, bond prices rise and yields fall in times of sustained weak economic growth. Investors reap the benefits of capital gains on their bond portfolios.

Big institutions are slowly becoming 'equity friendly', anticipating a period of decent, if not spectacular, earnings growth--like that of the late 1990s. The Merrill Lynch survey of 302 fund managers with assets of $994bn showed that investors have been wary of bonds and bullish about most equities for six years. The bank said: "Once again equity market bears are becoming an endangered species. Less than one in 10 investors was now under-weight in shares." Surprisingly, a majority of investors perceived America as the worst placement for their savings over the coming year. "There is a very strong bias away from America. US assets are as disliked now as they were at the height of the Enron and WorldCom scandals of 2002," Merrill Lynch added.

True, compared to the US, European stocks are relatively cheaper and European-based investors don't have to worry much about currency-risk. The probability of steep falls in either the euro or sterling against the dollar over the next two years is quite remote. Strategists envisage the dollar rates against the European single currency at 1.32; the yen 102; and the British pound 1.88 by the year-end.

Global capital markets are likely to see modest earnings growth over the next decade. This year, the S&P's 500 index is predicted to rise by 9%, while earnings growth could slowdown to around 10%--compared to impressive earnings gains of 20% in 2004.

Looking ahead, the US central bank has measured the pace of rate hikes and strong light crude prices--hitting new highs of $57.70 a barrel in New York--against the probable effects on equities. An environment of rising interest rates and average corporate earnings warrants a more 'defensive' equity stance--with increased exposures to pro-cyclical stocks such as energy, oils, mining, telecoms services and healthcare. Currently, oil shares of the super-majors, notably ExxonMobil, Royal Dutch Shell and Total, offer attractive valuations. With strong worldwide demand led by North America and China and limited spare OPEC capacity (below 2mb/d), the majors' cashflow may well receive a further boost from still higher prices during the year. Goldman Sachs, the US investment bank, has made wild predictions of oil skyrocketing to $100 a barrel--although this scenario is extremely unlikely for the foreseeable future.

The US boasts the largest and most liquid bond market in the world and is a natural beneficiary of global savings seeking a home. The central banks in East Asia and the GCC countries--especially Saudi Arabia, Kuwait and the UAE--are principal buyers of US Treasuries in order to support the dollar's value in Forex markets. Sizeable purchases of US government paper by foreign central banks have underpinned bond prices, thus preventing yields from decisively breaking through the 5% threshold.

But most surveys indicate general bearishness towards Treasuries, reflecting tighter monetary conditions, large budget deficits and the risk of dollar crisis.

On balance, 2005 may not prove to be an exceptional year of strong gains in global stock and bond markets. However, for Arab investors taking at least a 10-year position, equities should offer superior returns to bonds and cash (money market deposits and certificates of deposits). According to Barclays Capital Equity Gilt study, real (inflation-adjusted) UK government bond returns over 50 years have averaged a paltry 1.7% per annum and cash deposits 1.9%. By contrast, equities produced real returns of 6.3% during the same period.

PRIME STOCK MARKETS IN PERSPECTIVE

                                     (%)
                        April 1/05   change             Dividend
                        year         Yield **   P:E *   Yield **
New York:
Dow Jones Industrials
(Prime 25 Blue-Chips)   10,404.30    +0.3       19.1    1.71

S&P's 500               1,172.90     +3.6       19.5    1.80

Nasdaq 100              1,469.35     +1.0       N/A     N/A

Tokyo:
Nikkei 225 Average      11,723.63    +0.3       28.0    1.07

London:
FTSE 100                4,914.0      +11.4      14.5    3.09

Paris:
CAC-40                  4,080.08     +11.2      15.0    3.96

Frankfurt:
DAX                     4,373.53     +11.4      12.1    2.18

* Price: Earnings ratio--the measurement of the common
stock or ordinary share price to the earnings per share
over the latest 12-month period. The higher the ratio,
the higher the market expectations of future earnings
growth. ** Dividend yield--the ratio of the dividend
per share to the market price expressed as a percentage.

MATURE GOVERNMENT 10-YEAR BONDS

              April 1/05   Year           US Treasury
                           Change         Bonds Yield
                           Yields         differential

US            4.48         +0.60
UK            4.74         -0.04          -0.26
Japan         1.35         -0.07          +3.13
Germany       3.62         -0.34          +0.86
France        3.65         -0.39          +0.83
Switzerland   2.28         -0.26          +2.20

SHORT MONEY RATES (%) 3-MONTHS

              April 1/04   US$
                           differential

Dollar        3.07
Sterling      4.90         -1.83
Euro          2.14         +0.93
Yen           0.04         +3.03
Swiss franc   0.72         +2.35