Naturally enough, with the Monetary Policy Committee (MPC) of the Bank of England joining the US authorities in more ‘monetary tightening’ (i.e. raising interest rates), stock market investors are concerned about the effect that this will have on economic growth, especially as it seems that rates in the developed economies have not peaked yet, with the MPC having already indicated that there may be more to come.

Chris Burvill, manager of the Gartmore Cautious Managed fund, is one of those who believe that there could be more to come from the MPC. He says: “Signs of a slowdown in the US economy have helped pull longer-term interest rate expectations down in the UK but I’m not sure that is right. The UK economy is still growing healthily and pricing pressures are intensifying. A few months ago we might have cheerfully brushed inflation concerns aside by suggesting that higher prices were purely down to rising oil prices. With oil now nearly 30 per cent off its summer highs and core inflation still ticking up, those arguments are less convincing. We could see anything up to a 1 per cent increase in interest rates over the next year before the MPC feels confident that inflation is back under control.”

Chris Iggo, senior strategist at AXA Investment Managers, adds: “The market now has to contend with the risk that rates will be increased again. The MPC’s statement gives no real clues about future policy bias except to say that it judged the rate increase was necessary to bring inflation back to target. Further rate increases would come if the MPC thinks that there is inflationary pressure in the business sector stemming from a lack of spare capacity and increased pricing power, and from concerns about higher wage settlements and a boost to consumer spending.

“Since the beginning of August, short-term interest rates have moved up by 50bp (0.5 per cent) and the trade-weighted value of sterling has increased by 1.7 per cent. This is a reasonable tightening of overall monetary conditions, although strong credit growth and rising house and equity prices are potentially offsetting this. For 5 per cent to be the peak in rates, we need to see the CPI inflation measure peaking at current levels (2.4 per cent), further evidence of slack in the labour market and some easing of mortgage demand and house price inflation. The MPC thinks that the outlook for the UK’s main trading partners remains positive, so signs of a further easing in global growth will also be required.”

There is, however, no consensus amongst fund managers as to the direction of future base rate moves. Fredrik Nerbrand, head of investment strategy at HSBC Private Bank, opines: “Although the Bank of England has raised its rates, the debate about what the next move might be is more interesting. Futures markets are pricing in a chance of a hike early next year. In our view, the likelihood of further hikes is exaggerated, as inflationary pressures are likely to abate as global growth moderates, which will inevitably push energy prices lower. This should limit top line inflation numbers and put to rest any amplified inflationary fears that the Bank of England might experience at the moment.

“The political environment in the US has shifted back to what has historically been the norm. A divided government tends to limit any extremes in spending behaviour and should do the same this time around. Overall, this should promote budget restraints that should lead to a more balanced fiscal policy, which is less likely to continue to be as growth-supportive as in the past and limit any subsidies that preferential sectors have received. Even though most of this is now priced in, the ramifications on asset allocation should not be underestimated. The environment is likely to shift more towards growth fears than inflation fears, which should favour bonds over cash, but equities should remain king of the hill as long as the growth numbers are not terribly bad.”

Equity fund managers still see opportunities for gains at home and elsewhere. Hugh Yarrow, co-manager of Rathbone’s Income funds, says: “There are good reasons for market gains, not least of all continued flow of strong company earnings, takeover activity and a falling oil price. However, there are risks to the outlook too, and these do not seem to be fully discounted in several areas of the market. Monetary tightening in most major economic regions continues, while US consumption still looks exposed to the housing market’s deterioration.

“With these risks remaining very real, we believe that a prudent approach is warranted. The value we see in the market is on a stock-specific level, and we are particularly focusing on those stocks best placed to grow throughout the economic cycle. We are confident in the strength of the underlying companies in the portfolio, and this should place the funds on a solid footing.”

His colleague, Carl Stick, manager of Rathbone UK Special Situations, adds: “Equity markets continue to be optimistic, with many global indices hitting highs during October. For instance, the FTSE 100 reached 6,200, its highest level since the beginning of 2001. However, we are still seeing investors shying away from the smaller stocks. The oil price fell a little further, and this is buoying consumer confidence and increasing spending power, particularly in the US, as falling prices at the pump leave more money in the pocket. Furthermore, with the US natural gas price falling, household bills are also likely to be considerably lower during the last quarter.

“In the UK, confidence is also high, driven to a large extent by the clear upward trend in the housing market. Data suggests that the economy is growing at a healthy rate, and with money supply growing strongly, we are not surprised to see interest rates increased to 5 per cent. As always, we continue to focus on company fundamentals and use share price volatility to add to companies with strong, long-term business models. When the market realises how underrated many of these companies are, we expect this fund to be very well positioned to benefit.”

As for the Japanese recovery, the managers of funds investing in this market remain confident that it still has some way to go, but that next year it will be the turn of Japanese small and mid caps to outperform. For example, Taeko Setaishi, manager of the Atlantis Japan Opportunities Fund, insists: “We are positive on growth for the Japanese economy and believe three factors will drive this: consumer spending is picking up as wages and bonuses are increasing, exports are strong and growing, and finally, private-sector capital investment is running at its highest level for 10 years.

“Bigger stocks have outperformed this year in Japan, but we believe it is the smaller and medium-sized stocks that have better earnings growth potential over both the short and longer term. In valuation terms, medium sized and smaller stocks are selling on about the same PERs as much bigger stocks but have much better long-term prospects. As Japan is a fairly mature economy, many of the more traditional manufacturing and heavy industries have stopped growing or at best will grow only slowly. We will continue to concentrate on the smaller stocks and not get caught up in the short-term market fashion for the bigger industries.”

Key indicator: Thai Interest Rates (12 December)

The Bank of Thailand meets on 12 December to decide whether to move interest rates â“ currently on hold at 5 per cent. Far from derailing Thailand’s stock market, the military takeover from the Shinwatra government was greeted with relative calm, ending months of political uncertainty. Consumer confidence in Thailand rose to a seven-month high in October, as falling oil prices eased inflationary pressure. Expectations are that interest rates have reached their peak at 5.0 per cent. Some forecasts put 2006 GDP growth at 4.2 per cent â“ the slowest rate for five years â“ which has prompted speculation that interest rate cuts of up to 0.5 per cent may be on the cards over the first half of 2007.
Source: Gartmore

Key indicator: Indonesia (14 December)
Indonesia’s central bank has been cutting interest rates since May in a bid to stimulate economic growth, having recently revised down its 2006 GDP growth forecast to 5.6 from 5.8 per cent. Interest rates in Indonesia are among the highest in Asia after they were raised to 12.75 per cent in 2005 to battle inflation and a sliding currency. However, appreciation in the Indonesian rupiah over the second half of 2005 coupled with slowing inflation has allowed the central bank to shave 2.5 per cent off the benchmark rate over the last six months. But, with the spread between Indonesian rates and US rates narrowing, there is uncertainty over whether Bank Indonesia will implement another cut when it next meets in December. Concern is mounting that the bank will slow the pace of interest rate cuts in the face of resilient US economic growth.
Source: Gartmore

This article is from the December 2006 issue of What Investment.