Financial Times, July 19th
LEX: US markets
It's the growth, stupid. The apparently endless expansion of the US economy - now in its ninth year and still growing at around 4 per cent - continues to set the tone for US financial markets.
Equities, as so often, have had the best of it. Domestic demand, helped more recently by a recovery in world growth, is producing an unexpectedly strong rebound in earnings growth from last year's crisis. This has pushed the stock market to new heights, with a total return of 12.4 per cent for the S&P 500 in just six months. And dollar strength, particularly against the euro, has brought foreign investors healthy currency gains to boot.
The only black spot has been bonds, as strong economic growth has led to an increase in long-term inflation expectations and thus higher yields. The total return for the 30-year Treasury so far this year has been a disappointing minus 9½ per cent.
The second half should be somewhat better for bonds. Most investors are expecting the Federal Reserve to raise interest rates by a further 25 basis points this autumn - but no more than that.
With 2-year bonds yielding 5.54 per cent against a current Fed Funds rate of 5 per cent, a tightening of that magnitude is already built into the short end of the yield curve. And if it achieves a gradual slowing of the economy to, say, 3 per cent - which is all the Fed wants - yields at the long end should be able to drift gently down from their current 5.90 per cent.
Inflation worries will cause jitters from time to time, given rising commodity prices. But last week's benign consumer price numbers, showing that core inflation has actually decelerated to an annual rate of 1.6 per cent in the first half, suggests few worries on that front for now.
Equities may find it harder to live up to their star billing now the big secular decline in interest rates is past. Strong earnings growth, expected to reach 10-12 per cent this year and 5 per cent in 2000, is bullish, of course. But the international recovery bringing it about is a double-edged sword, since it brings with it higher input prices. That could put pressure on the market's price/earnings ratio, which is already at a sky-high 29 times for 1999.
Meanwhile, liquidity, which has long helped to underpin shares, is starting to shift. Mutual fund inflows are running 20 per cent below 1998 levels and share buy-backs have also eased. Overseas investors have taken up the slack, both through portfolio investments and directly - there has been more than $100bn of foreign takeovers of US companies so far this year. This reduction in supply pushes up valuations as investors chase scarce stock. But demand, particularly from overseas, can quickly reverse.
The last time foreigners were big buyers of US stocks while US investors were big sellers of foreign stocks was in ill-fated 1987.
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