Fed helps push US back on track
Thanks to decisive action from the country’s central bankers, equities markets in the US are back on track, say equity strategists. Fears that the US was facing a serious economic downturn – reflected in the sharp fall in stock prices in early April – have all but evaporated.
The US Federal Reserve has slashed the cost of short-term borrowing by 2.5% since the beginning of the year and the latest market rally shows that investors at least are convinced the easing has been effective, they say.
“We think the equities market has started a new bull cycle,” says Christine Callies, chief US investment strategist at Merrill Lynch in New York. “It will be of average length – 12 to 15 months,” she adds. Within this period, she sees a target for the S&P 500 index of 1,570. The index currently stands at around 1,280.
Right now, says Callies, the principal investment themes for US stocks are economic recovery, capacity restraints in most industries and a revival of capital spending.
The Dow Jones Industrial Average is now back up to levels last seen in August and September 2000 at 11,200. The benchmark has recovered sharply since its lows seen on April 4 this year of below 9,500. The S&P 500 is now around 16% higher than its low seen on that day, while the technology-laden NASDAQ index is up 32%.
The first signs that conditions were improving for equities came from the bond market, says Matthew Wickens, global economist at ABN Amro. The yield curve for 10-year US government bonds started to turn down and then flatten out.
But it is the dramatic fall in short-term interest rates which has really spurred the market to make a recovery, with the Fed cutting rates rapidly since January. “It has been the most aggressive easing since Greenspan started at the Fed in 1987,” says Wickens. “Obviously the Fed was surprised by the pace of the slowdown,” he says.
The US central bankers have acted in contrast to the European Central Bank, which has been criticised for acting to hesitantly in easing the cost of credit amid signs of economic weakness. Wickens says Federal Reserve Board governor Alan Greenspan appears to have taken the approach favoured by Bank of England governor Eddie George, who said: “A stitch in time saves nine.”
The economic slowdown witnessed by the market late last year was in part an inventory adjustment, and as such may turn out to be a temporary blip, he says. “We’re not saying the economy is out of the woods yet – it’s still going to be very difficult,” he says. However, the upwards sloping yield curve suggests there is considerable optimism in the money and bond markets. “Financial markets are telling us it’s a cyclical downturn and everything is going to be OK,” he says.
Stock prices are particularly buoyant now that they have penetrated the lead ceiling of 11,000 on the DJIA. “Markets always look for key thresholds and clearly 11,000 was one,” says Wickens.
The Fed’s series of rate cuts have shown the market that it means to bring the economy back to its growth rate of 4% as opposed to the 2% currently indicated, says Rupert Della Porta, head of North American equities at Aberdeen Asset Management in the UK.
“We are now coming to the view we’re starting to get near to the time when the liquidity boost from the Fed will more than compensate for the dangers the market is facing,” he says.
“Some time after that we’ll start to see a rebound in profits and the market will be looking to discount that about nine months ahead,” he says.
Commerzbank forecasts US GDP growth of 1.8% for 2001. Its analysts say that while headline CPI in the US has remained high in a historical context due to a strong rise in energy prices, the upward trend in prices has recently subsided. This low inflationary environment means the Fed is able to cut rates aggressively to stimulate growth, they say.
Market sentiment received an additional boost in mid-May, when the Fed accompanied its interest rate cut with a statement that inflation was not a worry.
Strategists agree that the country’s vast technology sector, having suffered so severely in the market downturn, has more rebound potential than most industries. “Technology is really very cyclical… their earnings ebb and flow with economic growth,” says Della Porta of Abderdeen. “These firms have liquidating their inventories quite quickly so they will see the benefits early on,” he adds.
Although the economic picture now looks bright for US equities, there are still downside risks lurking, say strategists.
“The main risks are that we are not near a bottom in the stockmarket – that there is an ongoing problem with the consumer, and that unemployment goes higher,” says Della Porta.
Investors should therefore keep a close watch on jobless figures.