The investment landscape in 2000

After a decade of outperformance, the US equity market will struggle to keep pace with Europe and Japan. But US treasuries will do better this year than last, particularly if the US equity market corrects (as I expect).

The euro will eclipse the US dollar as the strongest major currency as growth accelerates in the eurozone. The yen will drift lower, but not until after the end of the current fiscal year in March.

As last year, the internet will remain a driving force of investment returns - even if volatility remains high. The web is here to stay, reshaping the corporate landscape globally. Those companies that respond quickest to the challenge of e-commerce may face rising investment outlays now. But they'll be the leaders of the future, as volume gains drive down the marginal cost of doing business.

Global inflation is rising again. Producer inflation is already up sharply from levels a year ago and consumer inflation is gradually following suit. The cost of capital is set to jump higher too. Real long-term interest rates have been contained below their long-run average for the past three years - but that's about to change.

First, central bank injections of Y2K-related liquidity will dry up. As rapid expansion of narrow money in Q4 of 1999 gives way to outright monetary contraction during Q1 of 2000, financial asset prices will come under pressure. Second, the combination of faster growth, accelerating inflation and rising interest rates will increasingly bear down on excess liquidity - the difference between global broad money and nominal GDP growth.

During the 1990s, European equities consistently underperformed US counterparts. But accelerating EU growth prospects and minimal inflation risk will allow European equities to turn the tables. Germany will lead the show. Unemployment is falling fast, which will underpin a consumer-led recovery of 3% real GDP growth this year. The German government may have sent mixed signals with its misguided support of Philipp Holzmann and takeover target Mannesmann. But moves to cut the tax burden on households and corporates (particularly abolition of capital gains tax on sales of cross-shareholdings of domestic companies) will help attract capital back to Europe.

Indeed, one of the major shifts that I expect to drive financial asset prices over the next few years is the death of the post-war restructuring model as the mantra for three big world economies: Japan, Germany and Korea.

Their economic models were founded on the need for national reconstruction after terrible destruction - and so have many things in common. All are by tradition industrial economies - good at making things but bad at services. You only have to compare global demand for BMWs to Steigenberger hotels to get that one.

All three economies based much of their economic culture on self-sufficiency and economic nationalism. For all three, "output" was competitive globally, but "inputs" (such as ownership, resource allocation and labour practices) were "national" and often shielded from market and competitive forces.

These models were very successful but are now breaking down because they have passed their use-by date. Several forces are causing them to implode. The need for corporations to be competitive on a global scale for input factors, such as capital and human talent, as well as on output, is one such force. The consolidation of most sectors into a few global players is another. The emergence of the service industry as a dominant determinant of growth is a third, particularly as this sector is at a comparative disadvantage in all these economies and is one they have to buy into.

The advent of the single market and the euro, important as a competitive response by Europe to globalization, is also a local driver in ending national economics in Europe. The need for German banks to go global and get the resources to do so by selling their shareholdings in the non-financial corporate sector is the catalyst for supply-side reform that the German government has just empowered.

The economic model that will be substituted for the post-war reconstruction one will be the Anglo-Saxon market-driven one - with local characteristics. The benefits to investors will be huge. There will be a shift in management principles to maximize shareholder wealth externally and reward excellence internally. A supply-side revolution will boost productivity and sustainable growth, while lowering inflation (as we have argued before, radical supply-side reform is not deflationary, even in the short term). Corporations will focus on core competencies in global (not national) markets. The nexus between government and corporate sectors will be severed, so releasing resources for more efficient and productive use and diminishing corruption.

These changes will make core European financial assets very attractive. I reckon that core European equity markets are about to enter into a long period of outperformance over US equities, based on greater change for the better at the margin, cheaper valuations and moderate foreign ownership ratios. The euro will be boosted by investment flows buying into the Americanization of core European economies. That will reverse the current wave of capital flight from Europe. A strong economic cycle that will close the growth gap with Japan and the US has already begun and will help strengthen the euro. Indeed the euro will be the world's strongest currency over the next two years.

Japanese stocks will join the Europeans in outperforming the US. The driver is Japan's improving profitability performance. As companies embrace the mantra of restructuring, by reducing their stock of labour and fixed assets, return on capital will soar.

The turning point in the fortunes of US liquidity conditions and asset prices will play havoc with the dollar. The massive current account deficit in the US, more than half of which was covered by net M&A-related capital inflows between Q1and Q3 of 1999, will become unfinanceable unless domestic demand slows.

The euro will recover ground against the dollar - indeed, it has already bottomed out after its flirtation with parity. The yen will slide too - Japanese base money growth will gradually exceed that in the US (and the EMU zone) as the Bank of Japan injects liquidity to help finance the government's increasingly acute JGB-funding dilemma. I expect the euro to climb to $1.15 to $1.20 and for the yen to slide during the second half of the year.

Emerging markets will outperform developed ones, after three years of lagging. This is linked to the upturn in the global commodity price cycle, which this year will broaden across a wider range of raw materials. But in a world of tighter liquidity, it's countries least dependent on foreign capital inflows - and those less geared to US interest-rate shifts - that will outperform. Developing Asia and emerging Europe will do better than Latin America.

David Roche is president of Independent Strategy, a research firm based in London. www.instrategy.com