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GLOBAL FINANCE _ AN OVERVIEW

Global equities survive higher interest rates

V. Anantha-Nageswaran

Against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the Committee believes the risks are weighted mainly toward conditions that may generate heightened inflation pres sures in the foreseeable future.

_ The US Federal Open Market Committee

WITH the much anticipated rise in the Federal Funds rate and the discount rate by 25 basis points this week by the US Federal Reserve, the stage is now set for contemplation of the next FOMC action in March. The above statement, extracted from its press release, shows clearly that the FOMC is worried about risks of higher inflation than weaker growth. That is, the Fed remains biased to tighten.

Short rates rise expected

This move was widely anticipated. Nor is it a surprise that the Fed remains concerned about higher inflation. Fourth quarter GDP growth (5.8 per cent) topped even the most optimistic of expectations and the Employment Cost Index for the same quarter rose faster than expected. Furthermore, the `Prices Paid' component of the US National Association of Purchasing Managers Index surged to a five-year high in January. Topping it all has been the spectacular report on new jobs created for the month of Januar y. Average hourly earnings _ a broad measure of wages in the economy _ rose 0.4 per cent leading to renewed fears of higher wage and production costs. Higher costs could lead to a margin squeeze or higher inflation. However, there is no need to fear the worst on both counts

First, wage growth, per se, is not inflationary unless it is not matched by productivity growth. The higher GDP growth in Q499 actually has forced to us to revise upwards our expectation for productivity growth in the US. This data is due to be released on Tuesday and will show a much stronger non-farm productivity growth. We expected upwards of about 2 per cent and now the non-farm productivity growth rate could be as high as 3 per cent and above. Manufacturing productivity growth in Q499 is likely to be around 8 per cent _ impressive for an economy about to complete its ninth year of expansion. What about the first quarter?

Outlook for inflation remains sanguine

The increase of about 11 per cent (YoY growth in Q499) in the non-residential fixed investment category augurs well for continued productivity growth. In turn, continued steady growth in non-residential investment is indicated by the rise in orders for n on-defence capital goods excluding aircraft. Capital expenditure remained high as the economy entered the New Year.

Nonetheless, inflation will be higher in 2000 than it was in 1999 but not enough to warrant fears of a return to the bad old days of wage-inflation spiral. The higher inflation rate in 2000 will come mainly in the first half of the year as the base effec t of higher oil prices begins to drop out of the index in the second half. What are the risks to our benign view on inflation?

ALesser room on supply side to absorb demand, that is, capacity-utilisation rates are on the rise while capacity addition slows down in the US as global demand picks up soaking up available supply elsewhere as well;

AContinued robust demand tempts a pass-through of prices to retail consumers; and

ASlower productivity growth.

Asset markets volatilityto continue

Slower productivity growth could result either in higher inflation or a margin squeeze that will adversely affect stock prices.

Furthermore, with the Fed signalling that more tightening is to come, US stocks will continue to remain volatile. The minutes of the December 21 FOMC meeting reveal that the Fed continues to bet on the elusive waning wealth effect from possible stock mar ket declines to curb consumer spending. Such a scenario has not materialised and that means a demand slow-down will have to be induced by the Fed and the Fed alone.

As the Fed contemplates higher rates, it has to decide on the desired level of tightening especially if higher inflation remains a threat only on paper. Sustained monetary policy tightening may not only be unnecessary but also harmful if it chokes invest ment spending and productivity growth defeating the very purpose of higher interest rates namely, to keep inflation under check. Nonetheless, another 25 basis-points rise in the Federal Funds rate in March appears to be a near-certainty.

Amidst all these uncertainties, investors should devote more than a passing interest to equity-linked notes (ELN) or capital protected units (CPU) on US stocks. As was the case last year, stock-picking skills in the US market will be tested. Broader mark ets are unlikely to collapse in a heap; nonetheless, winners will remain narrow. Earnings disappointments will hurt stocks badly (Lucent Technologies, for instance).

US bonds to drift up, drift down

We anticipated the recent rally in US bonds (refer to comments in CS Weekly issues in January). However, the magnitude of the rally, especially in the 30-year segment, is surprising. Given the strong economic data, the rate hike and the promise of furthe r rate action in months to come suggest that the rally in the 30-year Treasury is overdone while the 10-year Treasury yield may have somewhat more room to fall.

In accordance with the theory that equates real GDP growth with the real rate of interest on long bond, the equilibrium nominal yield on the 10-year Treasury should be around 6.2-6.3 per cent. This assumes a real rate of around 4 per cent, compared to th e long-run historical average of around 3.0 per cent and an expected average inflation rate of between 2.2 per cent and 2.3 per cent.

The plunge in the EUR disappoints

The plunge in the value of the EUR against the US dollar was not expected considering continued corporate consolidation (Vodafone and Vivendi and Vodafone and Mannesmann, for instance) and rising economic confidence in the Euro-zone. Barring special fact ors, it is hard to fathom a steep decline in the value of the EUR. While a stagnant EUR against the US dollar in the wake of the still favourable growth-inflation trade-off in the US would have been understandable, a slide on the scale that was witnessed remains inexplicable.

Explanations centre on political developments in Austria: EU sanctions on Austria due to the inclusion of a far-Right party in the governing coalition and the implications it has for the stability of the monetary union and Germany's fund-raising scandal in the Christian Democratic Union. They are not entirely convincing. Therefore, despite the risk of drawing cynical smiles, we remain bullish on the EUR for the rest of the year.

We reiterate our central case for Europe this year: strong growth and low inflation. Economic confidence in the Euro-zone countries is at a 10-year high. The recent rise in inflation in the Euro-land is unlikely to be sustained. Acceleration in Euro-land inflation was expected in the first half of the year in the wake of the weak EUR. However, underlying inflation pressures are absent and, therefore, the inflation rate should drop in the second half of the year.

...while European technology sector

begins to outperform the US

The woes of the EUR have not exactly rubbed off on European equities. That is a blessing. German and French equity markets have remained relatively resilient while the Swiss equity market too has showed a tendency to bounce back. Some of the select stock s in our European stock recommendation list have outperformed their US contemporaries (ST MicroElectronics, for instance). Nokia and SAP too have continued to stay ahead. The resilience of the stock market underscores our optimism for the currency.

It is the UK market that has proved to be disappointing since it is caught in the throes of fears that the economy is likely to face a repeat of the familiar boom-bust syndrome. We do not share those concerns and expect inflation to stay low. The housing market may be strong and consumer spending may be too high for the comfort of the Bank of England. The key is whether such robust economic activity is generating higher inflation. The evidence is rather weak.

Australia raises interest rates

The Reserve Bank of Australia, in a pre-emptive move, raised the cash rate by 50 basis-points to 5.5 per cent. This move came in the face of still-low inflation data and strong retail sales data in recent times. That the Australian dollar had fallen shar ply from around 66 US cents to below 64 must be categorised along with other bizarre events such as the inversion of the US 10- and 30-year Treasury yield curve and the slide in the EUR against the US dollar.

At the risk of sounding repetitive, the Australian economy is expected to maintain its recent trend of strong growth and low inflation. As argued in the last column, wage containment, monetary policy vigilance and low inflation may have social costs and such costs may rise over time. However, in the short-run, such a policy framework has to be positive for asset prices. We reiterate our bullish views on the Australian dollar and equities.

And the yen drops, at last

The Japanese yen has gone above 105 to the US dollar. At a rate below 108, it is still overvalued and, as mentioned in the past, the factors that led to the EUR to weaken must apply to the Japanese yen too.

In the final analysis, all that has happened in the last fortnight: Several rate actions, violent exchange rate movements, stock market volatility and the continued rise in oil prices _ have not forced us to review our outlook for global asset markets. B onds and stocks are volatile for the time being. Currency movements are overdone. US rate hikes are not over yet but the stock market is unlikely to collapse. Investors will miss a few heart-beats but the direction for asset prices will still be North, t his year.

(The author is regional head, Investment Consulting _ Asia-Pacific, Credit Suisse. The views expressed are personal. Feedback may be sent to nageswar@singnet.com.sg)