Beginning in late March of this year, the environment for US stocks had changed. The most critical d...
Beginning in late March of this year, the environment for US stocks had changed. The most critical development has been the improvement in the world economy with Asia including Japan stabilising. In the US, consumers have continued to drive growth and have amassed significant levels of debt while unemployment has hit a 30-year low.
At the end of June, the Federal Reserve responded to these issues in addition to concerns about US financial asset appreciation by increasing the Fed Funds rate to 5%. Worries of global deflation that had overhung the market have been replaced by fears of global inflation.
Before the Asian economic crisis, the world experienced a period of economic stability (ex-Japan) with generally declining prices. In the past, an expansion of this duration would normally result in inflation. This time has been different. Increased globalisation and productivity gains from technology have been the main reasons.
The Asian crisis, while causing severe dislocation in the world's capital markets, actually helped to continue the trend as the global slowdown also worked to keep inflation at bay
Last year, in response to global market instability, the Federal Reserve initiated three rate cuts fuelling higher stock prices. Through early 1999, investors sought the earnings consistency of large cap growth companies. These stocks outperformed all other sectors of the market with the narrowness of the advance, the difference in returns and the dispersion in valuation all reaching unprecedented levels. March marked a change in the dynamics of the equity market as well. There was a significant rotation into small cap and value stocks as investors sought greater earnings leverage to the improving global economy.
Volatility has increased and the tone of the market has become less sanguine as investors digest the economic data and comments from Alan Greenspan. The summer rally has lost steam as even strong earnings announcements were not enough to offset fears of higher rates. The S&P 500 has fallen more than 5% from its highs while the Nasdaq composite is off more than 10%. Uncertainty will likely remain as investors weigh the likelihood of higher rates against the positive outlook for earnings
After raising the discount rate at the end of June and removing the tightening bias, Greenspan reiterated in July's congressional testimony the need to be looking for signs of impending inflation. Accordingly, the Fed is prepared to act in August should the data warrant it. With the tight labour market, the two conditions necessary to avoid tightening are a further acceleration of productivity and a weakening of the pace of final demand.
Given the recent economic data, especially the uptick in wages, an August tightening appears imminent. With the market at steep valuations, stocks need a catalyst to support higher prices. As a result, we are cautious about the near term. However, we see reasons to be optimistic. We remain positive about the longer-term growth prospects for the economy and corporate profits. As a result, we continue to emphasise high quality growth stocks in our portfolios.
Peter Goetz is product specialist at Dresdner RCM Global Investors.
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