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The US Federal Reserve Bank could be on pause for some time and rate cuts are not expected

The sun’s rays have broken through the investment clouds, allowing a degree of light to be shed on the current global economic situation. In the US, the markets seem to have settled into the view that the US Federal Reserve Bank will be on pause for some time to come and that early rate cuts are not on the cards.

The US economy seems to be on course for a gentle deceleration in activity. Housing is very weak but, with jobs growth and income gains still healthy, there is no reason at this stage to expect more than a modest slowdown in consumer spending.

In Europe, the European Central Bank has softened its rhetoric and indicated that they may be nearing the end of their current monetary tightening drive. The Bank of England is expected to increase rates before Christmas and then pause. Japan appears on course to raise rates gradually.

Apart from the monetary developments, there were few economic events of interest during the past month. Most of the data confirmed that economic growth rates had passed their peak but, for the most part, data pointed towards a continued healthy global expansion. Activity in Europe is still very robust and in Japan, the Tankan survey of business confidence was stronger than expected.

On the inflation front, the pull-back in commodity and energy prices has been a welcome development. This probably means that we have seen the worst of the pressures from this area but with activity levels still high across the globe, it will probably take some time before we see consumer headline inflation figures fall significantly.

Turning to the markets, the major risk to fixed income is probably a likely rise in real yields. Real yields on index-linked bonds have fallen recently, leaving them at very low levels. In the case of the UK, there will probably be a seasonal effect supporting them into the year end. After that, we expect a very slow rise in real yields.

Conventional bonds, as represented by the US market, had become expensive on fears of the slowing US economy. The recent pull-back leaves them in the middle of our forecast range. We still believe that corporate bonds are expensive but we do believe that there are selective opportunities in emerging market local issues.

We have become more upbeat on equities. Market responses to the tensions with North Korea indicated that it would take a new dimension of threat to unnerve investors. This leaves us with equity markets looking attractive on most comparisons with bonds and cash. If growth proves robust margins might well hold their recent record levels. At the same time, the inflation threat and the prospect of a harsher monetary regime is fading.

Within equities, we continue to favour the UK and Europe. The main reason is still the attractive arbitrage between the cashflow yield on the equity market and the low cost of corporate borrowing. We believe that as long as bond markets remain well-behaved, the flurry of private equity buyouts will persist. This game will only come to an end when central banks move to aggressively tighten rates.

Elsewhere in equity markets, we have become more positive on the prospects for Singapore and Hong Kong. Within emerging markets, we prefer the strong domestic Asian economies over Eastern Europe, the Middle East and Africa. We are particularly downbeat on the prospects for the Latin American markets following weaker commodity prices.

For currencies, we have become quite defensive on the Canadian dollar due to weakening commodity prices and signs of slower economic growth. We still rate the yen as attractive but in view of the huge interest rate differential, there seems no imperative to have huge positions in place there yet.

Percival Stanion is head of asset allocation at Baring Asset Management

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