The US Federal Reserve still has a delicate balancing act to perform – trying to keep a lid on inflationary pressures without tipping the economy into recession. And with more credit tightening likely before the central bank considers the danger to be past, strategists see little room for growth in US stock prices this year.
However, Jeffrey Davis, chief investment strategist for State Street Global Advisors (SSGA) in Boston, says his firm expects to see modest appreciation in US equities over the rest of this year. By the end of 2000, the S&P 500 index could show growth of 12% over the year, he said. At the moment, it is still virtually unchanged from the end of last year.
Market expectations of higher interest rates to come would put profit margin pressure on some companies, he added. “The real problem is employment costs right now... everyone in the financial services industry is feeling the crunch,” he says. In April, the rate of US unemployment fell to 3.9%, which was the lowest level seen for 30 years.
Higher employment costs and a number of other factors, including scarcer capital for internet companies, will slow the economy in the coming months, says Davis. This will lead to a soft landing but certainly not a recession.
Forecasting equities prices would broadly remain flat for the rest of the year, one US strategist from ABN Amro says valuations are at least becoming more realistic. “The factors that have driven the US market to do nothing so far will stay with us,” he says. “For some time, US equities have been expensive,” leading to worries about a possible crash.
But while he acknowledges this is a risk, he says any sudden and severe drop in market prices was unlikely. It is interest-rate sensitive stocks – utilities, financials and possibly hi-tech stocks – that are most likely to suffer in this environment of rising bond yields, he says.
Earlier this year, the market was very volatile, particularly in the technology sector. This was driven by the fact that many investors have been borrowing to invest, which has added to demand. But Gail Dudack of UBS Warburg says there are signs this frenzy is past its peak.
“Volume has started to dry up, and this is in part the end of leveraging,” she says. However, the market will continue to be volatile for some time, she adds.
As expected, the Fed opted to hike the Fed Funds rate by 50 basis points in mid-May. UBS Warburg forecasts another 50 basis point rise later this year, and Dudack says speculation about interest rates is likely to keep the market stirred up until then. “There is room for a lot of changes in psychology on the way,” she says.
In the past year, the Fed has raised short-term rates by 1.75% in an effort to slow the rapid pace of economic growth. The economy grew at an annual rate of more than 6% in the last six months of last year, and hardly slowed in the first three months of 2000 to 5.4%.
However, following the latest rise in rates, some analysts think the Federal Reserve will not rush to make another move, but instead wait a while to see if its actions are in fact enough to slow growth.
Dudack forecasts the Dow Jones Industrial Average will end the year at around 10,000, hardly changed from current levels. Meanwhile the technology-heavy Nasdaq should fall to 2,700 from around 3,500 now, she predicts.
“Technology has been the focus for much of last year, and will continue to be so,” she says. “The debate later in the year will be, if the Fed is going to slow the economy... is the technology sector cyclical or not?”
Though some argue that it is not, she counters that the sector is cyclical because it depends on capital expenditure. And while factors such as Y2K preparation and the active IPO market in the sector have raised both revenues and capital for the technology sector, neither of these boosting factors will continue, she says.
Although he expects growth in the broader market, Davis of SSGA also predicts the Nasdaq will remain volatile, ending the year up, but by less than the S&P 500.
The biggest risk for the US market over coming months, says Davis, is the euro’s exchange rate. “That’s the real wild card... further weakening in the euro could cause problems for exporters in the US,” he said. The European Central Bank may opt for ‘tag-along’ interest rate rises to mirror the Fed, he says.
However, Davis also notes that the Japanese economy is continuing to gather strength, which is good news for exporters.
Emerging signs that fast US economic growth might actually be feeding through into inflation meant credit would become more expensive, says Nick Bennenbroek, international economist at Deutsche Bank.
Early indicators of accelerating growth, such as strong auto sales figures and orders for consumer durables, had been seen. “The core measure of CPI rose quite strongly in March which we hadn’t seen before,” he says.
He forecasts 10-year government bond yields will peak at 6.75% by end of the year, compared with around 6.43% now. But mortgage rates, which influence individual spending in the economy, are not likely to rise to the same extent, he notes.