US interest rates are crucial
Fed may raise rates in H1 as the global upswing continues
business-times.asia1.com.sg
THE year 2004 has started with a change in focus. We are now reaching the stage in the cycle when economic news confirming the recovery that was previously considered good will now be taken negatively by asset markets. This is because it will signal that interest rates are on the way up.
We continue to believe that the key thing to watch in 2004 will be US interest rates. A recent change in rhetoric from the Federal Reserve ensures that this area remains in the spotlight.
Once the timing of any US rate increase is known there are trades in bond, currency and equity markets that will start to unwind as investors begin to allocate assets more defensively.
Real GDP in the US grew at a 4 per cent annualised rate in the final quarter of 2003. This was slower than the 8 per cent growth recorded in the third quarter.
It was, however, a signal that the drivers of growth have broadened with investment spending, export growth and the long-anticipated rebound in inventories all helping to take the pressure off the consumer. However, the US employment situation remains crucial.
Aggressive cost cutting by companies helped to improve growth and profitability last year, but what we need to see now is confirmation that companies have sufficient confidence in the recovery that they are ready to start hiring again.
The non-farm payrolls data is a crucial indicator and will be keenly anticipated by the Federal Reserve. They will be looking for signs that the recovery is assured before they start to raise rates.
In Japan economic indicators are pointing to a sustainable recovery. The Tankan business optimism survey remains at a high level. Japan is a very cyclically geared region and as a result is benefiting from the global upswing.
The global upswing should last through to mid-2004, boosted by sustained low interest rates and tax rebates.
Continued strength from our lead indicators, as well as low inventory levels, suggests that the global upswing could last another six months. The US will, in our opinion, continue to lead the global economic cycle.
We believe that the lift in global growth will be insufficient to close the global output gap. This spare capacity will keep downward pressure on core inflation rates. But there will be no general deflation outside Japan because service sector price inflation proves 'sticky'.
The Fed may increase interest rates in the first half of the year. In the UK, we believe that slower consumption will prevent the Bank of England's monetary policy committee from raising rates too far. And the strength of the euro should prevent the European Central Bank from raising rates.
Government bond yields were slow to respond to positive economic news in the first few weeks of 2004. They have, however, started to pick up in the last few weeks as expectations of a rise in short rates have dominated.
We believe that the insensitivity of US treasuries may be because foreign central banks have become large holders as a by-product of preventing their currencies from strengthening.
Currency markets continue to be dominated by dollar weakness. Sterling is very interesting. It is very strong at close to $1.85 against the dollar; however, on a trade weighted basis, sterling is flat.
Yen intervention
The Japanese authorities are intervening heavily in the yen spending US$67 billion in January alone. This is a third of the total spent during 2003.
Short-term interest rates in the UK are heading up. The Bank of England has signalled that the high level of consumer borrowing is a concern.
We believe that it will adopt a 'wait and see' approach. Heavily indebted consumers are more sensitive to aggressive rate rises than ever before.
We believe that bond yields will rise in the short term as economic growth rates improve.
Fair value for western bonds is somewhere around 5 per cent. This is thanks to low and stable inflation. It is possible that bond yields may rally in the second half if growth begins to weaken.
The dollar is now close to fair value, especially relative to the euro. It could over shoot, however, as the US struggles to finance its huge current account deficit.
The Japanese authorities may struggle to prevent the yen from appreciating, as it appears to be the most overvalued currency.
Bond returns look unexciting on a 12-month view.
In the UK, the expectation that interest rates will have to rise significantly looks to have gone too far. This leaves the UK offering the best value bonds (in local currency).
We believe that index linked bonds are overvalued and consequently will produce very low returns. The UK equity market has started the year lagging the global pack. Its very defensive sector composition means it should benefit as the cyclical trade comes off later in the year. This internal rotation means that even without technology, equities can still make steady progress.
The recent equity market rally has left sentiment looking very bullish. In addition volatility, measured here by VIX, is also at very low levels. While not a 'sell signal' these two measures do highlight the vulnerability of sentiment to any equity weakness.
Earnings, which have provided a strong support for equities in recent months, are now also showing signs of rolling over as this revision data shows.
In Europe it is likely that currency strength is having an impact. Whilst in the US some slowdown from the very impressive levels of 2003 was inevitable.
The recovery in companies revenue growth coupled with continued cost restraint will cause 2004 to be another good year for economic growth.
Threats
If we see a drop off in economic momentum the prospects for 2005 will be less good. Equity markets might rise further in the short term as optimism about the global recovery builds.
If this move up pushes markets into expensive territory they will be vulnerable to any perceived drop off in economic growth. On a 12-month view we expect that most markets will post decent gains.
The first half of 2004 should see equity markets being driven by economic and earnings news. We expect that relative returns in Europe and Japan will be positively impacted by currency appreciation.
The spread between the yield on high yield bonds and US treasuries collapsed in 2003. Low inflation and low short-term rates forced investors further up the risk curve into high yield.
We believe that this story is nearly told and as with emerging market debt there is little left to play for in this area.
Asian equities have run up strongly with improvements in global economic sentiment. As the chart shows Hong Kong has been a big beneficiary here especially the real estate sector.
This is another trade that is closely tied in with the US interest rate cycle. The liquidity cycle in the US is at a critical point. Broad money growth has been slowing for some months now. But inflows into equity mutual funds are running at incredibly strong levels, stimulated by previous monetary injections. If the slowdown in broad money growth continues it is unlikely this will be sustained. |
