LONDON, 4 April 2005 — The US Federal Reserve raised rates 25 basis points after both its FOMC meetings in the first quarter. The statements issued after each meeting are closely analyzed by investors wanting to understand better the thinking of US policymakers. The immediate conclusions drawn from the March 22 statement are that the US may have a somewhat bigger inflation issue than previously thought and that the period of rising US rates may therefore get extended.
Markets sold off in the wake of the Fed’s meeting. As a result, many US stock and bond indices now show a negative return year to date though, with a few trading days left in the quarter, European and Japanese stock and bond return indices are mostly in positive territory.
The data continue to show that the world economy is doing reasonably well, despite oil prices now back over $50 a barrel and the possibility that they rise still further. The US expansion is now starting to generate some decent job growth. Recent activity data for Japan have been strong. In the mean time, in the lagging European mainland economies, industrial production figures have been better than expected, though business sentiment remains fragile. Overall, however, the implication is that the world economy can withstand higher US rates.
Meanwhile, the balance of evidence indicates that US inflation is picking up, even if the overall level remains low. Arguably the medium-term inflation assumption embedded in US bond yields is now in the range 2.5 to 3 percent.
With nominal US GNP rising on average around 6.5 percent over the last year and with the real (volume) growth approaching 4 percent, the widespread feeling is that Fed funds are too low at 2.75 percent. Forward rate curves now indicate Fed funds at 4.25 percent a year from now. Allowing for the traditional tendency for the forward curve to over-predict upward moves, this suggests another 1 percent rise in US rates over the present tightening cycle.
Interest rate trends thus indicate a challenging market environment for the next few months. Right now, areas of the market that have done well recently are facing the most pressure. In fixed income markets, non-investment grade areas have sold off and, in equities, emerging markets and property/housing related stocks have been hit. Over time, we would expect that, as interest rates rise, investors will start to anticipate some economic slowdown.
That might allow a recovery in longer-dated bonds and in turn a better tone in the equity markets. Such a shift looks to be a few months away though lower prices will tend to tempt “value investors” in the meantime.
Our asset allocation remains a cautious one. The equity weighting is 25 percent and our total return products will have a weighting at the lower end of their allowed range for the time being. Within the equity commitment we are recommending an increased weighting in Japan. This is chiefly on account of the better investment environment developing there but it is worth noting that Japan brings some diversification benefits to a global portfolio.
Our cash and bond allocation is now 50 percent, with a heavy emphasis on short-dated paper. The balance — 25 percent — is in alternative investments. Here, our focus is on low-risk fund-of-hedge fund vehicles. We look to our exposure here to provide some protection in the event of near-term weakness in mainstream bond and equity markets.
As for equities, we retain our focus on energy even though this sector has done extraordinarily well. In general, however, we favor a broad spread across the major industrial sectors. We have added Japan to our list of favored areas this month.
At present we do not expect a significant move in US dollar exchange rates. We note, however, that with rising US interest rates an increasing number of commentators are turning more positive on the US currency. Our favored currencies remain the yen and, within Europe, sterling.
(Habib F. Faris is vice president at Clariden Bank, London.)
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability, or completeness of the information.)