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Bumpy approach

What sort of ride can bond and equity investors expect as Federal Reserve chairman Ben Bernanke tries to bring the US economy down to a soft landing? By Matt Goodburn

There is a general consensus that the US economy is heading for a slowdown but opinion is divided on how severe it will be.

The latest US manufacturing statistics and its house price index indicate that a fairly sharp downturn could be on the cards. However, most commentators agree that Federal Reserve chairman Ben Bernanke intends to cut interest rates next year, which could help cushion the economy from the anticipated slowdown.

JP Morgan Asset Management global strategist Tom Elliot says bond markets tend to react to longer-term expectations but can move quickly if rates are cut too fast.

He says: “If the market thought Bernanke was being too aggressive by cutting the rate to 4 per cent over the next two months, bond markets might go up to 5.5 per cent to price in the risk. Ten-year bond yields could come down for every 25 basis points cut in the base rate.”

He says the prospects for equities are better in the short term. “As interest rates fall, corporate borrowing becomes cheaper. Cutting interest costs on debts is a boost for the economy and good for earnings but the flip side is that demand may fall, which could shrink company toplines.”

ABN Amro asset management head of investment strategy Richard Duncan says the ideal scenario for bonds and equities would be a soft landing for the US economy in the next few months so as to avoid a full-blown recession.

However, he says the latest round of US economic indicators, particularly from the housing market, make the risk of a hard landing more likely. He says October saw the biggest monthly fall in house prices for 35 years of 9.7 per cent compared with a 16 per cent rise in the same month last year.

He says: “At the end of June, 10-year bond yields peaked at 5.25 per cent but now they have dropped back down to 4.57 per cent.

“Already the market has sensed that the US economy is slowing, so bond prices have already moved up. Next year, as they cut rates, then the 10-year yield will start dropping and bond prices will go up.”

Duncan believes that if the US base rate is cut as expected early next year, the short-term prospects for equities are reasonable but not so good further out.

“The equities markets in the US and Europe have done well recently, while Japan has not, because the market has enjoyed decent growth and market sentiment has been strong,” he says. However with a harder landing now more likely, he believes that company returns may disappoint and equities will struggle to keep climbing.

Duncan says: “The equities outlook in the short term is good but, depending on the severity of the downturn, it could become a lot trickier 12 months out.

“It could also force the Fed to cut the rate by more than 50 basis points, which would be a good environment for the government bond market but corporate bonds would be unlikely to do quite so well.”

Royal London Asset Management economist Ian Kernohan says the way equities and bonds fare in any US base rate cut will depend on what is priced in.

Kernohan says two-year yields on US bonds are at 4.65 per cent compared with Federal funds which are at 5.25 per cent, indicating that the bond market has already priced in a rate cut next year.

He says the market is priced for at least two and possibly three cuts before the end of 2007.

“I would expect equities to rally on any clear signal from the Fed that it is about to cut rates. My preference would be for equities because I think they will do better from a rate cut than bonds,” says Kernohan.

Abbey Investments head of client investment John Kelly says: “The general view is that interest rates have peaked and over the last few days there has been a growing feeling that they will fall in the first part of 2007. Bond investors’ current risks are much higher now than further out, so the Fed might be tightening too much.

“If the bond market is right on interest rates, the equity markets are anticipating a future the bond markets do not see.”

Artemis strategic bond fund manager James Foster believes the recent good performance from US and European government bonds and, to a lesser extent, UK bonds has been bolstered by the Fed’s more benign recent outlook.

“The UK was one of the worst performers but still produced positive returns while both the US and Europe performed very well. The pause from the Fed and the more sanguine comments from Bernanke have set a more positive tone for bonds,” he says.

Threadneedle head of US equities Cormac Weldon remains bullish for the equities if a likely rate cut goes ahead early next year and says the pattern has had a positive effect in the past.

“While we think that consumer growth is likely to slow, there are factors offsetting its effect on the economy. The yield on the 10-year treasury bond, which is the key rate for setting mortgages, has fallen 50 basis points from its peak and there is already talk of consumers and homeowners refinancing their debt.

“We would argue that it is time to look beyond the noise of fragile short-term data and focus on what are still very sound fundamentals. Inflation is falling, economic growth remains strong in global terms and the Federal Reserve looks to be in a position to lower its base rate early next year. In past cycles, this scenario has been very positive for the markets.”

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