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V. Anantha Nageswaran

All economic indicators — the Fed moves, bond and interest rates, the dollar-euro trends, Japan's outlook and Asian equity scene — suggest the second half of 2004 being propitious for non-dollar fixed income than for equities, which happens to be the mirror image of what happened in the second half of 2003, says V. Anantha Nageswaran.

IN A week filled with data, central bank meetings, policy statements and interviews, the final denouement on the state of the world economy came from the US employment report for June. This column noted on June 7 that the May payroll report would not be bettered for several months. It is always encouraging to find early success.

In June, non-farm payroll expanded only by 112,000. Figures for April and May were revised down marginally. Median duration of unemployment shot up to 10.8 weeks from 10 weeks in May. Are jobs really that plentiful as the Conference Board surveys are suggesting? More than the decline in the number of jobs created, the sharp decline in the index of aggregate hours worked suggests that the growth in output in the second quarter could be a lot lower than what consensus expects. Wage inflation remains rather mild. The annual rate of increase in average hourly earnings is barely 2 per cent in June.

This column has commented on the unusual rise in corporate profits in this recovery and the unusual sluggishness in wage growth. American consumers have, hence, relied on debt, tax cuts and refinancing to maintain their spending patterns. With the latter two unlikely to be available in the near future, the only recourse left is debt. Any further enlargement of household debt would be deeply troublesome to the American and, by extension, to the global economy.

The demise of the American consumer optimism has been predicted many times in the past and such forecasts have turned out to be premature. However, with retirement of the post-World War II generation approaching, the probability that the American households would be rudely awakened to the perilous state of their balance-sheet, is increasing. When that happens, expect American growth rate to remain depressed for a protracted period. Neither the US stock market nor the global ones are priced for this risk at all. When that occurs, it would initially be significantly negative for the US dollar. However, the culmination of the rebuilding of national savings would and could herald a period of US dollar strength. That would be a story for the next decade, however.

Fed bound to be wary of raising rates

For now, the payroll report is, thus, a culmination of a series of weak economic data and vindicates the cautious and reluctant move by the Federal Reserve on Wednesday. After all the excitement, the Fed action and explanation were rather tame. The Federal Reserve raised the Federal funds rate by 25 basis points to 1.25 per cent as market anticipated.

No surprises there. The text accompanying the statement was milder than expected. Inflation was attributed to transitory factors and the Fed expects further tightening to be measured.

Overall, our view remains that the Federal Reserve had probably begun its tightening move when the growth is slowing. Many indicators in recent times point in that direction.

They are orders for durable goods, the ISM New orders index, Walmart and GM Sales expectations for June, the lower-than-expected vehicle sales numbers, the sharp decline in Chicago Purchasing Managers' Index, the downward revision to the Personal consumption expenditure in April, the larger trade deficit figure for April and the jump in the initial jobless claims in the last two weeks.

The column of June 21 argued that 2004 would not be a repeat of 1994. That view has been bolstered by recent data and the Fed action. Hence, we reckon that the Federal Reserve would tighten by a maximum of another 50 basis points this year (at most). Indeed, the chances of seeing no rate hike in August have improved significantly. The Federal Reserve would be a reluctant central bank when it comes to increasing rates. This author reckons that America's personal debt would trap them into low rates and lowering mode next year.

Merrill Lynch North American Chief Economist, Mr David Rosenberg, has just produced a very interesting chart. He calls it his `Boom-Bust' indicator . The Federal Reserve normally finishes its tightening when the index rolls over. Now, it has already begun to roll over. What it means for the Federal Reserve tightening agenda is rather obvious.

Bullish for bonds and interest rate products

The tame employment report set off a big rally in the Treasuries. The 10-year Treasury note yields 4.45 per cent down from a high of nearly 4.85 per cent. Tepid economic growth and a rollback of interest rate expectations would strongly support the bond market in the months ahead. It is good news for emerging economies such as India and their interest rate outlook.

We would favour bond markets outside the US, as we remain steadfastly bearish on the US dollar. Australian and New Zealand dollar bonds yield more than the US counterparts, and their currencies would remain well supported by interest rate differential now that the US interest rate expectations would start to wane. With hopes of interest rate cuts in the Eurozone waning, we would look to shift allocation from Eurozone bonds to other places.

Interest rate-structured products — such as CRANs or inverse floaters — would be appropriate to consider, at this time. We continue to favour Swiss franc funded bond portfolios in euro, Canadian, Australian and New Zealand dollars and in pound-sterling. We would favour a greater allocation to the euro in this portfolio than to the Canadian dollar. Election results in Canada have raised concerns on the continued soundness of fiscal policy in the northern neighbour. The Liberal Prime Minister has retained his post but with the Left-of-centre social democrat support. We do not share the pessimism (yet) but would like to remain watchful on that.

Housing risks require watching in the UK and Down Under

Both the countries have housing bubbles and, hence, it is important to watch for signs of stress in the housing markets down under. If such signs are evident, one should be prepared to exit quickly. Certainly, in Australia, the housing market has given enough signs of slowing down and, hence, the risk there is lower than it is in the UK or even the US.

Yet, the risk of a collapse of the housing bubble has not fully disappeared even in Australia.

In the UK, the Bank of England Governor, Mr Merwyn King, seems determined to cool the housing market and has openly acknowledged the importance of the housing market development to monetary policy decisions. Hence, the UK short rate could rise to 5 per cent from the present 4.5 per cent. Further, the pace of price appreciation in the UK housing market has not slackened as much in the UK as it has done in Australia.

Hence, the risk of a collapse of the housing bubble, when rates in the UK hit 5 per cent, is greater than it is in Australia. Hence, here too, investors diversifying out of the US dollar in search of higher yields have to be very watchful.

Dollar trend is down, euro to gain

The euro has resumed its advance, after the lacklustre employment report. The gains will be consolidated and further strengthened when US interest rate expectation cools off. The long-term (more than 12 months) price target for the euro is 1.35 or higher.

It will be mostly due to US dollar negatives than euro positives. While we trumpet the US dollar risk, we are mindful of the lack of alternatives. It is unlikely that investors would be willing to bet on emerging market currencies.

That might be a story for 2005 — and that too in the second half. That once again underscores the case for gold. As and when US rate expectations pull back, expect the euro and gold to advance against the US dollar.

Either the rising US trade deficit or the waning interest rate expectation prompted by with weaker growth would cause the US dollar to decline.

Ambivalent on Japanese equities

The Japanese equity market is more likely to be stuck in the 10,000-12,000 range, rather than move higher. The positives remain monetary policy support for economic expansion, corporate restructuring and partial bank reforms.

However, on the negative side, remains Japanese deflation, unreliability of Japanese macro and micro statistics (recent revelations of omitted pension contributions, overstatement of birth rates, Mitsubishi Motors) and continued uncertainty with respect to China's economy. Further, importantly, the Small Business Confidence Indicator that has been a reliable lead indicator for Japanese stocks peaked in March 2004 has been coming down in small increments since then.

Hence, we would not recommend any aggressive exposure to Japanese equities at this stage and would recommend that investors pare back.

Case for Asian equities remains elusive

We are unimpressed by the argument that moderating US rate expectations would be positive for Asian equities for the following reasons:

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