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Impact Investing

IPE special report May 2018

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Prophets of doom feel time has come

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The Jeremiahs on Wall Street have been predicting doom for the past five years – years that have also seen spectacular gains in the value of US equities. But a change of tack at the Federal Reserve and signs of economic recovery in Europe and Japan have swelled the ranks of the doomsayers in recent months, and this time they could well be right.
Analysts say concerns that a ballooning trade deficit and a weakening dollar will stoke inflation, could trigger aggressive rises in US interest rates. This would send Treasury bond yields higher and could end the long-running bull market on Wall Street, they say.
The extraordinary performance of US equities in recent years is itself a matter of concern for the central bankers. While Federal Reserve board chairman Alan Greenspan has never specified a preferred level for the Dow Jones Industrial Average, he has warned several times that the gains on Wall Street could be inflationary and look unsustainable.
The US has all but had a monopoly in attracting the world’s capital over the past few years. But it is time to wave goodbye to that as the European economy recovers and a long-awaited upturn in Japan starts to emerge. Investors would in any case be considering shifting funds out of the US to Europe and Japan, but a nasty-looking investment environment in America will only accelerate that process.
Dick Howard, an analyst at Bank Julius Baer in London, says the US had a free run in attracting capital in 1997 and 1998, but adds that with economic growth in Europe next year expected to reach between 2.5 and 3% the US will face stiffer competition.
Howard also predicts that the dollar, whose strength has allayed inflation fears and underpinned US government bonds for the last few years, “will be in for a rough ride over the next six months,” dogged by forecasts for a widening trade deficit.
Julius Baer’s house view is that the Dow Jones average – now at around 11,000 – “goes sideways for a very long time”. But Howard adds: “I wouldn’t be surprised to see a US stock market crash over the next 15 months” in the order of a 20–30% decline.
HSBC analyst Bill O’Neill is no less pessimistic. He sees a 15% decline on a nine-month horizon. “Our view is there will be further rises in interest rates, and the risk is that they rise more than people are currently expecting,” he said. O’Neill expects the Federal Funds target rate to rise to 5.75% by the second quarter of next year from 5.25% now, but the increase could well be more than that, he warns.
Although the dollar would normally be expected to strengthen as interest rates rise, analysts believe the outlook for the currency is clouded by the trade deficit. This widened to an all-time high of $80.7bn (e78bn) in the second quarter from $68.7bn in the first.
The strength of the dollar has kept a lid on US inflation for the past five years, but O’Neill expects a deterioration in the current account position – fuelled by consumer spending – to put “a phenomenal amount of pressure on the dollar”.
“There may be a mini-dollar crisis in the next six months, which might break the back of Wall Street confidence,” he says.
This kind of environment will see funds shifting into traditional safe havens in the equity market such as food manufacturers, utilities and insurance, analysts say, and away from the stars of the bull market in the high technology sector.
But despite dire warnings from some analysts, fund managers seem fairly relaxed about the outlook for interest rates and the impact on company earnings. The latest edition of the closely-watched Merrill Lynch Gallup survey of US fund managers found 57% expect the Fed funds rate to be higher in a year’s time, but almost all of these expect to see just one more quarter percentage point increase.
In the survey, published in the middle of last month, fund managers seeing a favourable profit outlook for companies outnumbered those seeing an unfavourable outlook by 6%. “The key question for global stocks is whether the US economy can slow in time to offset the inflationary impact of overseas economic recovery,” said Merrill Lynch global strategist Trevor Greetham on launching this month’s survey. “The stronger the overseas economic upturn, the more likely it is that US rates surprise on the upside.”
On the bond side, increases in Fed interest rates would push prices lower. Yields on 10-year US Treasury securities are expected to reach up to 6.5% in six months from around 5.90% now. David Sheard, head of rates research at Commerzbank in London, is forecasting 10-year Treasury yields of 6.25% by March, but this forecast assumes no tightening of Fed policy.

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