According to the research note put out by State Street Global Markets in mid-January: “2007 is proving a challenging environment for investors, with consensus trades being tested. Only two weeks into the year, the view that the US dollar would tumble as the Fed cut interest rates seems like a fond memory. Before the Christmas holiday break, Fed futures were discounting a near 80 per cent chance that one of the four FOMC meetings in the first half of 2007 would result in a reduction in rates. Since then most US economic data has been far stronger than anticipated and the probability of a Fed interest rate reduction in the first half of the year has fallen below 50 per cent.”

It added: “Central banks have also rediscovered their ability to surprise. The Bank of England raised rates, defying the consensus belief that the Monetary Policy Committee (MPC) would pause until the release of the Inflation Report next month. It now seems likely that this report will be in the horror genre and that the Old Lady will continue to seek to choke off the inflationary impact of wage inflation, a buoyant services sector and vertiginous house price rises. The ECB stayed put, but rate expectations are rising in Europe too, as Germany’s boom sizzles rather than fizzles.”

And the timing, if not necessarily the direction, of the latest MPC move in interest rates certainly caught the markets by surprise. Anthony Nutt, manager of the Jupiter Income and Jupiter High Income funds, commented: “I have been expecting further increases in interest rates in the UK, but the timing of this announcement is somewhat surprising. My personal view was that the MPC would look to increase rates in March or April but there has been some bullish data around so they are clearly choosing to act sooner rather than later.

“By acting early, it is possible that the MPC will be able to keep further rate rises to a minimum, but I would not suggest we are near the peak in rates yet. Interest rates are on the increase globally, and with consumers showing the kind of resilience they have, rates could reach 5.75 per cent in the UK before they peak. However, this does not change my view on equities. Company balance sheets remain in good health, valuations are reasonable and M&A activity is set to continue, so there is still the potential for healthy gains during 2007.”

John Clarke, chief investment officer of stockbrokers Goy Harris Cartwright, noted: “The problem with the MPC raising rates now, however, is that this will directly push up inflation, as measured by the Retail Prices Index and it is the RPI annual rate that tends to have the largest bearing on pay settlements. But even more fundamental than this, what we again appear to be witnessing is monetary policy being used to curb increases in ‘non-market’ prices. Yes, spending on the high street has not collapsed during the course of 2006, but this is only because retailers have been forced into further cuts in prices.

“Provided growth remains close to trend, or even slightly beneath it over the coming few quarters, it follows that the UK economy will be operating beneath its productive potential throughout all of 2007 and into 2008. We, therefore, continue to believe that inflationary pressures will ease over the course of the year. By further raising debt-servicing costs, which have already risen sharply over the last 18 months as a result of record personal-sector indebtedness, the latest increase in interest rates clearly increases the risk of a sharper deceleration in economic activity this year than we have been predicting – our forecast is growth of 2.4 per cent this year compared with 3 per cent for the Bank of England and the Treasury. However, on a positive note, it also increases the chances of lower interest rates before the end of the year.”

Similarly, Richard Dingwall-Smith, chief economist at Scottish Widows Investment Partnership, is forecasting that rates will be in reverse by the end of the year. “On our forecasts, inflation should fall back sharply from April onwards. Moreover, we expect that as 2007 develops, the Bank will be faced with growth developments both globally and in the UK which fall short of its expectations. Consequently we expect one or two rate cuts in the latter part of 2007, taking rates down to the 4.75 – 5 per cent range by the end of the year.

“The UK economy has considerable momentum in the short term but, in our view, is likely to slow a little in coming quarters. In particular, the environment for exports is becoming more difficult and business investment is projected to slow moderately from its recent strong pace. Consumer spending should continue to move ahead but at an unspectacular pace by past standards. Overall, we look for GDP growth to average 2.5 per cent in both 2007 and 2008, which is still below the latest forecasts from the Bank of England and the Treasury.”

Looking more broadly at the relative attractions of global equity markets, Jeremy Tigue, portfolio manager of the Foreign & Colonial Investment Trust, favours Asia and emerging equities in 2007. He says: “2006 was, without doubt, an excellent year for markets and this has helped propel the Foreign & Colonial Investment Trust share price tantalisingly close to its all-time high of 288 pence. Our expectation is that 2007 will see slower economic growth, a reduction of inflationary pressures and lower interest rates in the US, with perhaps one more rate rise in the UK and Eurozone. This benign backdrop should be good news for equities worldwide and ensure a continuation of the abundant liquidity which has been supporting stock markets.

“In other words, we expect ‘more of the same’ in terms of buoyant levels of M&A activity, fuelled both by companies seeking to expand though transactions, and deals prompted by private equity funds which are awash with record levels of cash. Mega-deals will be a feature of the market in 2007, thereby raising the prospect of attention starting to shift away from mid caps after years of strong performance, in favour of large-cap stocks, which have lagged for some time.”

But Tigue continues: “However, the principal risk to this rather benign scenario is a more pronounced fall in US house prices than the market anticipates combined with a rebound in oil prices above the US$80 a barrel level. We feel this is unlikely, but it would clearly unsettle investors, and when that happens markets tend to overreact. A key investment question in our mind is, therefore, whether the US will start to perform better once the interest rate cycle has peaked and of course the direction of the dollar. While everyone expects the US dollar to weaken further in 2007, it may be more against Asian currencies and not against the pound and the euro. It may therefore be time to lock into the current sterling/dollar exchange rate.

“In summary, we expect to see volatility rise in 2007 from low levels in 2006 with both risks and opportunities likely to emanate from the US. Given strong local fundamentals and our expectation that the dollar will weaken against Asian currencies, we are standing by our exist-ing overweight position in Asia and emerging equities.”

Key Indicator
Indonesian Economic Data (8 February)
Indonesia’s central bank has been cutting interest rates since May to stimulate economic growth. The January cut saw rates fall to 9.5 per cent, down from 12 per cent last May. The decision came only a few days after the government announced that inflation for 2006 had fallen to 6.6 per cent. The consumer price index hit 17 per cent in 2005. Most analysts believe that interest rates will fall further in 2007. The economy grew by an estimated 5.5 per cent during the year, below the 5.8 per cent predicted. The growth was largely fuelled by rising mining and commodities exports, the prices of which shot up on the world market, and to a lesser extent by consumer spending, which recovered in the second half of 2006. Source: Gartmore

Key Indicator
Thai Interest Rates (28 February)
The Bank of Thailand meets on 28 February to decide whether to adjust interest rates – currently on hold at 5.0 per cent. The central bank is seeking to regain credibility and restore confidence following its 18 December decision to introduce a 30 per cent reserve requirement on foreign capital inflows, a development that shocked investors and led to a sharp fall in Thai equities. It was hoped the move would dampen down the baht’s rise, which had hurt Thai exporters, by forcing speculators to keep their money in the country for at least 12 months or face a 10 per cent penalty. However, although the stock market has now recovered some of its losses, it may take some years before investors fully regain their confidence in the competence of the country’s policy makers. Most analysts expect the bank to cut interest rates by 25bps at the February meeting with further cuts followin. Source: Gartmore

This article is from the February 2007 issue of What Investment.