Most US economic statistics recently have indicated that the Federal Reserve’s tightening in monetary policy is having an effect. Housing sales and starts, measures of activity in the manufacturing and services sectors, anecdotal evidence from the steel and packaging industries and the latest Beige Book survey of regional economies all suggest that growth is slowing at last.
This is important for two reasons. Firstly, this means that we may now be nearing the peak of the interest rate cycle in the US. Over the last year the Federal Reserve has lifted the Federal Funds rate by 175 basis points to a nine–year high of 6.5%. Our calculations show that headline CPI inflation should rise from the current level of around 3.1% to 3.7% by the end of the year. The US labour market remains tight. It is not clear that OPEC’s latest decision to boost oil production by 700,000 barrels per day will have an impact on the price of oil. The bottom line is that the Federal Reserve will probably need to lift interest rates by another 25 basis points.
The second implication is that the world as a whole will continue to experience a combination of steady economic growth and relatively low inflation. The slow-down in the US is being matched by an acceleration in economic growth in the Euro-zone. The latest statistics show that, even in Germany and Italy, growth is beginning to pick-up. When the European Central Bank recently lifted its key interest rate 50 basis points
to 4.25%, ECB President Duisenberg indicated that this tightening in monetary policy would be the last for a while. Nonetheless, given that the Euro-zone as a whole is at a much earlier stage of a cyclical upswing than is the US, we would look for the ECB to lift rates by at least 25 basis points in the coming months.
This means that we are unlikely to see a brutal sell-off in stockmarkets as central banks move aggressively to crush inflation. It also implies that corporate earnings will, overall, remain reasonably robust. Our top-down analysis suggests that profits should grow over the next year by 3% in the UK, 14% in the US, 16% in Japan and 18% in the Euro-zone. Of course even when the global boom in technology, media and telecommunications stocks was at its height earlier this year many stocks were trading well below their highs.
We believe that it is still too early to say with certainty that the long-term downtrend in the Euro has been broken. Most recent trans-Atlantic corporate deals have involved European companies purchasing businesses in the US. Nonetheless, the acceleration of growth in continental Europe, together with the sharper rise in the Euro-zone, is consistent with a rally in the Euro against the dollar. We expect the euro to return to parity with the dollar by the end of 2000.
While the government bond markets are likely to be fairly neutral in this environment, with short-term interest rates moving higher and economic growth more likely to surprise on the upside than the down side, we see added value in the non-government credit markets. Credit spreads have recently widened to levels which provide a compelling total return break-even analysis, even if yields move higher in response to continued monetary tightening. However, we do prefer short dated credit issues.
Within our global equity portfolios, we are emphasising companies that can sustain superior rates of growth in earnings. The latest round of the debate over the various merits of growth and value stocks misses the crucial point: over the medium-term, the best returns will come from those companies that have leading positions in areas that are growing rapidly.
While global demand for semi-conductors remains strong, the price of chips should remain firm. We hold a number of leading semi-conductor companies in Japan and the East Asian NICs. We also favour companies that provide the infrastructure for the internet world-wide and certain key players in the European telecommunications sector.
The growth and deregulation of the financial services industry will provide opportunities for major groups that have powerful brands or overwhelming strength in particular national markets. Such stocks should also benefit from the ongoing high levels of corporate activity.
For institutional investors in the Euro-zone, the key features of the next six months should include the rise of the euro and the outperformance of major growth stocks world-wide.
Tony Broccardo is chief investment
officer of global products at Invesco,
in London