As the global economic expansion which took hold last year matures, we are passing into a new phase in the economic cycle. We are now in a period of more or less synchronised economic growth, and the very stimulative monetary policy put in place when we were in danger of slipping back into recession is no longer justified.
We expect authorities to begin to reduce the extent of that stimulus as the year progresses. Already, Australia, the UK, China and Singapore have raised short-term interest rates, and we expect other countries to follow suit. The largest impact will come when the US decides to move, and after the latest employment report, the huge retail sales figure and a poor inflation number, we believe investors should begin to anticipate a change there too.
This is not to say that we expect the Federal Reserve to act hastily. We are not replaying the events of 1994, when markets were taken by surprise and interest rates went up by 3% in a scant 12 months. Chairman of the Federal Reserve, Alan Greenspan, has given every warning that the policy accommodation will be removed, and we expect the US central bank to act in a measured way, raising short-term interest rates only gradually.
Even so, there is a danger that some investors will be caught off guard. Accordingly, we have decided to move from an overweight to an underweight position in equities, adding to cash instead. Aside from the potential threat from rising interest rates, there are several other reasons to be more cautious on equity markets over the next six months.
For one thing, it looks as if we are seeing the peak rate of change for US earnings growth at the moment. For another, it seems that our negative view on the prospects for the bond markets is now bearing fruit, with a sharp sell-off spreading from the US.
As bond yields rise, equity valuation multiples are likely to come under pressure. Add in the apparent deterioration in the political situation in Iraq, where we could potentially see some ugly developments over the summer and autumn months, it becomes difficult to see what will drive equities higher in the short-term, particularly in the US.
Outside the US, we remain confident that the economic recovery will gain momentum in Japan, where data point towards a self-sustained recovery. This could run for several more years, if the external environment remains positive, and the real estate and banking sectors continue their recovery.
However, the market has run hard for several months now, and banking and property stocks have been particularly strong. We expect to see something of a pause in the market, as investors take profits in areas which have performed well, and seek out undervalued investment opportunities.
While we are convinced of the long-term merits of exposure in the other Asian markets, this is admittedly no longer a new story. Short-term, attempts by the authorities to slow the pace of growth in China are likely to have a knock-on effect on exporters in the region, although domestically focussed companies are still likely to benefit from encouraging signs of stronger domestic demand.
Other emerging markets could also be vulnerable to higher US short-term interest rates, particularly in Latin America.
Turning to Europe, the situation remains largely unchanged, with a moribund domestic economy only partially ameliorated by stronger export orders. Political reform is off the agenda while the governments in France and Germany are being battered in local elections. The recent surge in east-European markets ahead of their inclusion in the European Union, argues for caution there as well. We don’t expect to see companies changing their behaviour now that the EU has increased in size again, as German companies in particular have been relocating manufacturing there for years.
In the UK, the environment is dominated by the surging housing market again. We do not expect that it will crack this year, but the Bank of England has given a very clear indication that it wishes to see the market cool down and will raise rates as necessary to achieve it. Equities are not expensive, but with selling pressure still coming from pension funds, we expect the market to make little progress.
Looking forward, our central scenario is for equity markets to give some ground over the summer months, perhaps culminating in a weak autumn as doubts about the US election and its aftermath become more severe. However, we are not anticipating a new bear market, or anything like it.
Instead, look for a summer shower and a moderate correction in prices which could well provide an opportunity to buy back equities at more attractive levels.
Percival Stanion is chairman of the strategic policy group at Baring Asset Management in London