Monday, 2 July 2007

Stocks ride out June turmoil but still face rising interest rates

June was a volatile month for stock markets and it is far from clear that investors will get to enjoy a calmer ride soon. Although inflation in the United States has moderated in recent months, global interest rates are still likely to go up in coming months, which could make further advances in stock markets difficult.

World stock markets held up reasonably well in June. This is especially after considering that they had to endure two major bouts of selling, first when bond yields spiked at the beginning of the month (see "Bond yields spike but stocks have cushion") and then, in the latter half of the month, when two Bear Stearns-run hedge funds holding collateralised debt obligations backed by subprime mortgages ran into trouble, raising concerns over wider market implications.

The table below shows the gains in the Morgan Stanley Capital International indices for the main developed stock markets. The German stock market outperformed both in June and in the year so far.

 Local currency
US dollars
Local currency
US dollars

As the Bear Stearns saga unfolded, there were fears that the write-downs and sell-offs that it was triggering could result in a spike in risk aversion and a generalised credit crunch. Those fears have not completely dissipated but markets have steadied themselves over the past few sessions. This means that the latest saga could yet turn out like other hedge fund debacles like Amaranth Advisors last year and Long Term Capital Management in 1998, where the fallouts were contained.

The problem, though, is that even if markets survive the latest episode, the risk remains that there are other hedge funds ready to implode. Whether markets can survive this and other potential hedge fund failures will depend partly on whether monetary conditions are tight to begin with.

In this respect, there may be reason to be somewhat sanguine as most analysts think that monetary conditions are not tight. Broad measures of money supply continue to grow rapidly all around the world. For example, the European Central Bank reported last week that M3 in the euro zone rose 10.7 percent in May from a year ago, close to the fastest rate in 24 years. Although bond yields had spiked at the beginning of June, they have since come back down. Liquidity remains ample and would help cushion any shock that comes along.

However, this in turn leads to the question of whether current conditions will be maintained. Central banks obviously are key here.

The most important central bank in the world, the Federal Reserve, is currently on hold. Events last week gave little reason to believe that this will change soon.

On Thursday, the Federal Open Market Committee decided to leave its target for the federal funds rate unchanged at 5.25 percent. In the statement accompanying its decision, it mentioned continued concern over inflation.

At the moment, though, inflation does not appear particularly elevated. On Friday, the Commerce Department reported that the core personal consumption expenditures price index that excludes food and energy rose by just 0.1 percent in May and by 1.9 percent over 12 months. Most Federal Reserve watchers think that it is comfortable when this indicator shows an inflation rate somewhere below two percent. Therefore, some analysts think that there is scope for a rate cut later this year.

However, inflation may not stay below two percent for long.

The Federal Reserve Bank of Dallas publishes two other measures of inflation based on personal consumption expenditures. The first is the overall personal consumption expenditures price index that is already reported by the Commerce Department. The other is the trimmed-mean price index that excludes components of personal consumption expenditures that have the highest and lowest rates of change.

The latest data provided on the Dallas Fed website show that these other measures of inflation remain above the Federal Reserve's comfort zone. The 12-month inflation rate based on the overall PCE price index was 2.3 percent in May and the inflation rate based on the trimmed-mean measure was 2.2 percent.

While it is possible that these measures of inflation will also fall below two percent, it is also possible that convergence in the various measures of inflation will occur the other way around. That is, the core inflation rate based on the price index excluding food and energy could rise above two percent.

Indeed, there is a good reason to think that the recent fall in the core inflation rate is temporary. The slowdown in the US economy over the past year has almost certainly played a large part in moderating inflation recently. However, with the economy expected to recover from the second quarter onward, further moderation is likely to be limited. In fact, many economists think inflation will re-accelerate as the level of resource utilisation in the economy remains high despite the recent slowdown.

The behaviour of oil prices recently certainly makes an acceleration in inflation look quite probable. NYMEX crude oil futures breached US$70 a barrel last week. It has risen about US$10 since the beginning of the year, with about half of the gain occurring within the past month alone. The Federal Reserve focuses on core inflation that excludes energy but it does not totally ignore inflationary pressure from higher oil prices because of the possibility of pass-through effects.

The prospect of a renewal of inflationary pressures does not necessarily mean that the Federal Reserve is likely to raise interest rates any time soon. However, it does mean that it is unlikely to cut interest rates.

In the meantime, other major central banks are still in tightening mode. Most analysts think that there will be at least one or even two more rate hikes coming from each of the European Central Bank, the Bank of Japan and the Bank of England before the end of the year as the economies in Europe and Japan remain strong.

So global monetary conditions will probably continue to tighten even in the absence of Federal Reserve action. This should be enough to keep global interest rates on the rise.

Furthermore, the events in early June show that markets have the power to push bond yields higher on their own. If overall inflation accelerates, they are likely to do so again.

Higher interest rates would weigh on equity valuations and make markets more vulnerable to shocks such as those arising from losses at hedge funds.

So stock markets may have weathered the storms in June but investors still face strong headwinds in the months ahead.

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