The release of the May CPI data in the US has ratcheted up interest rate expectations especially in the US, but also elsewhere. Core CPI, the series that excludes food and energy, rose 0.3 percent month-on-month for the third month running. Actually, the way the inflation data are presented - whereby monthly data are rounded up to the nearest decimal point - overstates the deterioration that has taken place. The less volatile year-on-year percentage change statistics shows a gain of 2.4 percent.
Federal Reserve Banks' governors have been going around saying that inflation is now above the Fed's "comfort zone." This is widely stated to be between 1 and 2 percent. The implication is that monetary policy needs to go beyond "balance" and to become outright "restrictive" if the inflation threat is to be beaten.
Two other considerations tend to support this conclusion: The first is that the labor participation rate in the United States is relatively high although it is difficult to say how far the low unemployment rate indicates a tight labor market. Also with the compensation for the more highly-skilled, highly paid work force now more "variable," the risks of wage inflation are hard to assess.
The second factor is the change at the helm of the Fed. The markets trusted the old chairman, Alan Greenspan. However, Ben Bernanke still has to earn that trust! In the past, in the context of a theoretical discussion of monetary policy, he made reference to Milton Friedman's helicopter drop of money as an emergency measure to stave off deflation. Some now call him "Helicopter Ben." In present circumstances Bernanke is most likely to gain the market's trust by reassuring the bond market that he is tough on inflation.
The November Fed Funds future contract now indicates that the markets expect that US interest rates will peak in coming months at 5.5 percent, compared with the 5 percent Fed funds current target. However, we should keep an open mind as to where the peak in US rates will be. The market has repeatedly and wrongly predicted an end to Fed tightening for sometime now.
(Fed, however, raised its benchmark US interest rates a 17th straight times on Thursday to 5.25 percent, its highest level since March 2001.)
In Europe and Japan, circumstances are rather different to those in the US. Inflation scarcely exists in Japan and, in Europe, core inflation is below 2 percent. The Bank of Japan and the ECB are therefore not aiming to be restrictive but rather moving policy away from being accommodative. The markets are having difficulty in working out what this implies! Currently the ECB repo rate is around 23/4 percent. Forward rates suggest a 1/2 percent rise by yearend with another 1/2 percent in 2007. On June 20, BOJ Governor Fukui said that monetary policy should be adjusted without delay. Markets are now pricing in 1 percent interest rates in Japan in the second half of next year.
We suspect that we may be close to some sort of peak in terms of interest rate pessimism. By the fourth quarter of this year, the markets ought to be in a position to anticipate a trend to lower interest rates in 2007. In the meantime we expect a choppy few months in which the market's fears move from anxiety about inflation to perhaps increased concern about recession. We don't believe that there is a really serious inflation problem now and we don't believe that there is a serious recessionary threat in 2007.
With this perspective, we view current market weakness as a nasty mid-cycle correction and not the start of a longer-term bear market. We furthermore look to better markets establishing themselves before the end of this year.
Expecting choppy markets, we retain our conservative asset allocation for the time being. The biggest risk that we run is with the 25 percent equity position. We keep this in view of our medium-term positive view on markets. Elsewhere, we keep 35 percent commitment to bonds and this month have extended our exposure to real estate from 5 to 10 percent. Real estate offers a relatively high income and, assuming continued economic and employment growth, some prospect on capital gain.
On equities, our strategy recommendations comprise investment themes that should deliver out-performance over the longer-term. However, in the present difficult market environment, traditional safe-haven industries such as health care or consumer staples will probably deliver a superior performance. We therefore continue to emphasize a diversified approach to equity investment with a broad representation across the main industrial sectors.
Finally, on foreign exchange, we recommend hedging forex exposure back into the domestic currency. However, over the next few months we expect that a continuing favorable news flow from Japan will support some appreciation of the yen. We recommend therefore that yen exposure of up to 5 percent of the total portfolio be unhedged at the present time.
(Habib F. Faris is vice president at Clariden Bank, London.)
(The information contained here in 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.)