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A tight spot

Following a nasty three-year cyclical bear market, equity markets generally bottomed in March 2003, rallying until May 2006 to then experience their biggest correction for three years. Does this weakness represent the start of something bigger? Are we about to revisit the low end of the range or is this merely a correction within an ongoing cyclical bull?

At this stage, the evidence favours the latter interpretation. The Federal Reserve seems to be steering the US economy towards a soft landing where growth slows to the point that inflation is kept under control but profits still grow. Even if it does overcook things a little, with interest rates now at 5.25 per cent, there is scope to ease policy to promote an upturn. What is more, equities seem to offer reasonable value, particularly relative to bonds.

There is still much that could go wrong. The hugely geared position of the US consumer makes life incredibly difficult for the Fed. If it tightens policy too little, inflation could continue to rise, but tighten too much and the economy could deteriorate. If deflation were to take hold, as in Japan, it might find it hard to resuscitate the economy with lower interest rates.

Inflation and the outlook for global interest rates were largely responsible for May’s correction. Higher volatility triggered a flight to quality as startled investors abandoned higher-risk investments in favour of safer investments in the developed world. These developments were not a big surprise as we had expected trouble in equity markets for some time. What was not expected was the disastrous performance of the Japanese equity market.

Many investors bought into the Japan story last year believing that “this time it’s different”, then headed for the exit at the first sign of trouble. We continue to believe things in Japan have changed fundamentally for the better. Deflation is on its way out and profits are growing impressively. At its recent low, the Japanese equity market was oversold in absolute terms and relative to other major markets.

As Asia develops, we expect the focus of the global economy to shift towards the East. That process is still in its infancy and what happens in the US is still the most important issue. If the US slows and pressure for higher interest rates is removed, investors should breathe a sigh of relief. But if growth slows to the point that the outlook for corporate profits becomes clouded, that relief may fade quickly.

Bond prices continued to slide in the second quarter, with the stockmarket slump providing only a brief period of temporary relief, but we foresee an economic slowdown that will ultimately cause bond prices to recover substantially.

The implications of slower growth for currencies are mixed. It may tempt investors to get back into higher-risk currencies on the basis that US interest rates will stop going up. We do not expect that to last. If slower growth ultimately causes investors to start talking about the possibility of recession, it is likely there will be another round of stockmarket volatility and flight to quality in currency markets. There may be a case for bottom-fishing in currencies like the New Zealand dollar but it is probably a limited window of opportunity.

Where to from here? Many of our indicators have been signalling the likelihood of some kind of bounce. The main reason is the fact that we believe the US economy is set to slow. That may sound counter-intuitive but, given that the setback in share prices was sparked by interest rate concerns, we feel that slower US growth would be welcomed by equity markets.

If growth slows to the point where investors start to question the outlook for corporate profits, there may be another down-leg in share prices. This would almost certainly motivate the Fed to ease monetary policy, at which point the cycle starts again.

Peter Lucas is director and global investment strategist at Ashburton

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