As expected, the Federal Open Market Committee (FOMC) moved its Fed funds target rate from 1.5% to 1.75% on Sept. 21. FOMC statements, released just after each meeting are examined in minute detail by analysts who seek to define shifts in Fed thinking. The September statement included the phrase that “inflation expectations have eased in recent months”. By contrast, the August release stated: “inflation has been somewhat elevated this year, though a portion of the rise in prices seems to reflect transitory factors.”
This change in wording was interpreted as a sign that the Fed is becoming more relaxed about the medium-term inflation outlook. Bond prices rose on the news, extending the rally in the 10 year Treasury from around 4.85% in early-May to just above 4 percent.
Forward interest rates now indicate much less aggressive assumptions so far as future Fed actions are concerned. Indeed, some say that the Fed may be done with raising rates by the end of this year. Driving these expectations is a growing anxiety that the US economy may be on the brink of a sharp slowdown.
Many project a weakening consumer as income growth will be modest and debt levels are high. For the three-year-old expansion process to gain traction some handover from the consumer to the corporate sector is required. Most of the financial conditions are in place — corporate indebtedness and debt servicing levels have fallen sharply and profits growth has been strong. One crucial ingredient seems to be missing — confidence. Few jobs are being added and investment budgets are not picking up.
A further consideration is the ballooning Budget deficit. If a serious effort is to be made to restrain it, tough measures are most likely to be announced next year — i.e. as soon as possible after the Presidential election so as not to provoke voter revenge in the 2006 Congressional elections.
As it happens, growing concerns about the US are balanced, at least for the near-term, by increased confidence in the expansion process elsewhere. The OECD has recently revised upward its forecasts for growth in 2004 for both Europe and Japan.
Moreover, emerging market economies are in general doing better. In Latin America, this substantially reflects a much-improved outlook for Brazil. Meanwhile, the recovery of Asian economies from the crisis of the late 1990s continues and high oil prices are, of course, good for the oil exporters.
Our suspicion is that growth estimates for the world economy in 2005 will come down over the next 6 months. The fact that oil prices are staying so high is not good news for energy-importing countries. Fears about the vibrancy of the US expansion have some foundation — not least because the current cycle is now 3 years old.
The recovery in Japan is no longer young and the full impact of restrictive policies in China has yet to be seen. By contrast, forecasts for modest growth in Europe and of continuing improvement in developing countries may prove more resilient.
For the near-term, we maintain our 25% allocation to equities, despite valuation concerns and the suspicion that market forecasts for US corporate earnings growth in 2005 are too high. We also maintain our 40% allocation to bonds, which has a focus on government paper balanced by higher yielding, less highly rated corporate credits. Cash is kept at a 10% weighting with the balance — 25% — being allocated to alternative investments, chiefly low-risk, fund of fund vehicles.
As for, equities, our assumption that profits growth will slow from here argues in favor of non-cyclical sectors such as health care and consumer goods. Elsewhere, we retain an overweight position in energy, though we have reduced our exposure in recent months. In terms of regions, our favored area is Asia, both Japan and the “Tiger” economies on the Asian Pacific rim.
Finally, of all the major currencies we are most positive on the yen. In particular, Japan’s structural trade surplus points to a stronger currency. Many currency pairs have fluctuated in an increasingly narrow range in recent weeks. At some stage a break out will occur but we are reluctant to predict the direction of major moves at this stage. With lower forecasts for UK interest rates, we have reduced our expectation for gains in the pound sterling.
—Habib F. Faris is vice president at Clariden Bank, London.
