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Bull market threatened by rising inflation and interest rates

The global bull market in stocks is now between two and a half to three years old. Despite the gloomy prognostications from bears, stock markets have continued to hit new cyclical highs over the past few months, thanks to a global economy that has surprised many with its resilience as well as stubbornly low interest rates. Looking forward, the question is whether the favourable conditions of the past few years will persist and continue to support stocks.

Recent data do not suggest significant weakening on the economic front. Forward-looking indicators continue to hold up well, with many even showing improvements.

Most significant of the latter are the purchasing managers' indices in the manufacturing sector. The global manufacturing PMI compiled by JPMorgan and NTC Research showed a sharp improvement recently, rising from 52.2 in August to 54.7 in September. This improvement was shared by a wide cross-section of economies, as reflected in the following table of national PMIs for the past two months.

	August	September	Change
US	53.6	59.4	+
Eurozone	50.4	51.7	+
Japan	53.8	54.5	+
UK	50.1	51.5	+
China	50.6	50.9	+
Australia	43.3	52.9	+
Singapore	52.2	53.1	+

The PMIs for the services sector were not as good. The ISM's non-manufacturing index, for example, fell to 53.3 in September from 65.0 in August. However, the CIPS/RBS index for the euro-zone rose to 54.7 in September from 53.4 in August. In any case, the indices remained above 50, indicating expansion.

Other indicators have also been positive. The Bank of Japan's quarterly Tankan survey found respondents generally positive on the business outlook in September, while in Germany, the Ifo institute's business confidence index rose in September.

About the only indicators that have tended to be negative are those for consumer sentiment. In the United States, where the consumer has been the engine of US as well as global economic growth, the latest readings from both the University of Michigan's and the Conference Board's measures of consumer confidence have been weak.

So the bears might yet be right. However, the bears might be right even if the economy is not quite on the brink of a downturn. Why? Because there is evidence that a stronger-than-expected economy may be bringing on higher inflation, which in turn may lead to higher interest rates. In the past, higher interest rates have more often than not signalled the end of bull markets, because firstly, they make equity valuations less attractive to investors and secondly, they hurt demand, which ultimately hurts corporate bottom-lines.

What evidence do we have of higher inflation? The US consumer price index for September was up 4.7 percent from the previous year, the biggest jump since 1991. In the euro-zone, the year-on-year inflation rate hit 2.5 percent in September according to a flash estimate, well up from 1.9 percent in January and the highest in over a year. Even deflationary Japan saw its core consumer price index fall just 0.1 percent in August from a year earlier, and land prices in Tokyo in July were actually higher than the previous year, the first rise in prices since 1990.

Of course, high oil prices are the main reason for higher inflation in most economies. And while oil prices had been moving higher for over a year on rising demand, the recent hurricanes in the Gulf of Mexico, which disrupted oil production, adds to the upward pressure on oil prices.

Not everyone is convinced that inflation is a threat, though. Some economists point out that outside of energy-related prices, inflation has been minimal. For example, despite the high headline inflation rate in the US in September, the core inflation rate, which excludes food and energy, was only 2.0 percent.

However, the Federal Reserve does not appear to be among those who are unconcerned with inflation. A number of Federal Reserve officials have come out over the past month or so stressing their concerns over rising inflation risk.

The minutes of the Federal Open Market Committee meeting on 20 September also show that the Federal Reserve appears more concerned about higher inflation than weaker growth. According to the minutes, in deciding to hike the target federal funds rate by 25 basis points to 3.75 percent, the committee was of the view that despite the devastation following the hurricanes in the Gulf, "aggregate demand and output would likely rebound before long". Therefore, "meeting participants were concerned that price pressures, which had been elevated before the storm, could climb further, primarily as a result of additional increases in energy prices".

It also pointed out that even after the latest interest rate hike, "the federal funds rate would likely be below the level that would be necessary to contain inflationary pressures, and further rate increases probably would be required".

The European Central Bank is apparently similarly concerned with inflation. Although it kept interest rates unchanged earlier this month, ECB President Jean-Claude Trichet also said that the bank is showing "strong vigilance" against inflation.

With all this inflation talk, no wonder US 10-year Treasury yields, which had been as low as 3.9 percent in June, are now around 4.5 percent.

However, central banks can be wrong. In fact, many economists doubt that the strength of either inflation or economic growth is enough to justify higher interest rates. As mentioned earlier, indicators such as the core inflation rate and consumer confidence indices could quite plausibly be used to support such views. Betting on higher interest rates is far from a no-brainer.

Then again, if inflation is low because of a weak economy, that might not be good for stocks either. In such a situation, you might still need an uptick in interest rates to tip the stock market over. It is just that you might need less of an uptick.

The current economic expansion has surprised many economists with its strength and resilience in the face of rising consumer debt and global economic imbalances. The strong economy has helped corporate profits rise strongly as well and sustained the bull market in equities.

However, investors should keep in mind that, at this stage of the business cycle, the best part of the economic expansion is over for most economies. On the other hand, inflationary pressures appear to be building up. Under such conditions, a rise in interest rates might just be the straw that breaks the bull's back.

Outlook for stocks in the aftermath of Katrina

Hurricane Katrina has been described as the worst natural disaster in the history of the United States. Whether the consequences will be disastrous for equity investors in general is another matter.

Katrina hit the shores of the Gulf of Mexico on 29 August, hitting the city of New Orleans particularly hard. The death toll has not been finalised. Earlier fears of a total of 10,000 dead have been scaled back as the official death toll remains in the hundreds. Nevertheless, the amount of destruction is clearly immense. Estimates of total damage caused by the hurricane are now over US$100 billion, while estimates of the impact on the US government budget are approaching US$200 billion.

Such a scale of destruction will obviously have an impact on US GDP growth, especially in the second half of the year. In addition to its generally destructive effects in Louisiana and neighbouring states, the hurricane has hit oil and gasoline production from the Gulf of Mexico. Consumer demand is expected to be crimped by the resulting higher energy prices, not to mention the negative psychology in the wake of the hurricane's destruction.

Last week, Treasury Secretary John Snow told reporters on Tuesday after a meeting with bank and financial regulators that the GDP growth rate could be reduced by "a half a percent or so". The Congressional Budget Office estimates a reduction of between 0.5 and 1 percentage point in GDP growth and a loss of 400,000 jobs.

A recent Bloomberg survey also found economists reducing their GDP growth forecasts and raising inflation forecasts for the second half of the year. The economy is now expected to grow at a 3.6 percent annual rate in the third quarter instead of the 4.1 percent forecasted a month ago, while the consumer price index is forecast to rise at a 3.5 percent rate from a year earlier compared to last month's forecast of 3 percent. For the fourth-quarter, the growth forecast has been reduced to 3.1 percent from the previous forecast of 3.5 percent, while consumer prices are forecast to rise 3.2 percent, up from the earlier estimate of 2.9 percent.

On the other hand, the rebuilding that is planned for the hurricane-hit region is likely to boost the economy in 2006. Whether all this spending would cancel the negative impact to GDP in 2005 is the big question.

Equity investors, however, had another reason to be hopeful in the aftermath of the hurricane -- a possible moderation in the Federal Reserve's tightening campaign. For example, Peter Brimelow, in a MarketWatch article on 5 September, cited Michael Burke of Investor's Intelligence as saying that the slowing economy means that "Fed rate hikes should no longer be needed", and low rates would provide support for the market. Indeed, bond yields fell in the immediate aftermath of the hurricane, the 10-year Treasury yield falling from about 4.2 percent just before the hurricane hit to a low of about 4 percent within a week.

However, recent robust economic data -- and perhaps more importantly, remarks by a couple of Federal Reserve presidents that inflation is a concern -- has diminished such hopes. The 10-year yield has backed up to over 4.1 percent.

As for consumer spending, retail sales data reported in the week following the hurricane have provided no clear indication of any change in trend.

So while among listed companies there are undoubtedly some that are likely to be negatively affected by the disaster and some that may benefit from it, at the moment, for the market as a whole, it may be too early to say whether the fundamentals for equities have changed much -- for better or worse -- as a result of the hurricane.

However, Richard Russell, editor of the Dow Theory Letters and, like Burke, much followed by MarketWatch columnists, recently provided technical reasons for optimism.

In an article on 7 September, Mark Hulbert wrote that Russell has turned "totally neutral on the stock market -- at least as to the secondary trend". The reasons: A new all-time high on the Dow Jones Utility Average and a potential upside breakout for the Standard & Poor's 500. Hulbert quoted Russell on the latter as follows: "The chart shows that if the S&P rises to 1,250, this would be a powerful upside breakout, with a large upside target hundreds of points higher." The S&P 500 closed last week at 1,241.48.

What may also be noteworthy is that Russell -- and Burke for that matter -- are bearish for the longer term. When bears -- especially ones with relatively good track records as Russell and Burke, as claimed by Hulbert and Brimelow -- are prepared to put aside their bearishness and acknowledge significant upside potential, even if only for the short term, I think investors should at least sit up and take notice.

And Hulbert has more to reinforce the short-term bullish case.

In an earlier article, Hulbert pointed out that the Hulbert Stock Newsletter Sentiment Index (HSNSI), an index that he uses to gauge the average recommended stock market exposure among a subset of short-term market timing newsletters, stood at 27.4 percent as of last Monday's close. This seemed unusually low to him; on 10 August, it had been at 52.2 percent.

Furthermore, the Hulbert NASDAQ Newsletter Sentiment Index (HNNSI), a similar measure for the NASDAQ, stood at minus 7.7 percent, which means that the average NASDAQ market timer is now net short the market. On 10 August, it had been in positive territory at 30.8 percent.

To Hulbert, "sentiment moves like the ones we've seen over the last month have more often than not been the precursors to rallies than declines".

On the other hand, investors who focus exclusively on the long term might prefer to ignore such short-term moves. In fact, for such investors, even Katrina may have little relevance. On this fourth anniversary of the 9/11 terrorist strike, it is probably worth remembering that over the long term, one-off disasters seldom have much long-term effects on stock markets as a whole. Hurricane Katrina is likely to be no exception.

Markets not moving interest rates to correct global imbalance

Low interest rates are increasingly recognised as a worldwide phenomenon. There have been several reasons advanced for the low rates -- global savings glut, weak global economy -- to which another reason has been added: the failure of capital markets.

A recent purveyor of this view is The Economist. On 18 August, it wrote the following in an article on its website:

The world currently displays an alarming number of large economic and financial imbalances. America's current-account deficit is forecast to widen to over $800 billion this year, while Germany, Japan and China look set to run record surpluses. Total government debt in rich economies has risen to a new high as a percentage of GDP, and in many countries households are sliding ever further into debt. Meanwhile, the growth rates of America and other rich economies have diverged to an unusual degree.

Many economists try to explain these trends in terms of underlying structural factors, such as differences in demographic trends or productivity growth. An alternative, more worrying, explanation is that the price signals that are supposed to bring the world economy back into balance have become distorted.

The Economist argued that countries with current account or budget deficits should face higher yields to compensate investors for the higher risk of a currency depreciation. However, using the case of the United States, which suffers from both a current account as well as a budget deficit, this has not happened. The Economist attributed the failure of bond yields to rise to Asian central banks buying US Treasury bonds to prevent their currencies rising and to cheap goods from emerging economies keeping inflation down and resulting in central banks holding interest rates down as well.

The Economist further argued that the liberalisation of international capital flows should have enabled markets to "punish economies where governments or households borrow recklessly with higher bond yields, prompting them to tighten their belts". However, this does not appear to have happened.

This is not really surprising. As I said in my previous article concerning the diminishing US personal saving rate (see "US saving deficit leads to trade deficit"), deficits that appear unsustainable over the long term can still last for a considerable period of time.

While the market will very probably eventually move to a sustainable equilibrium, the timing of such a move is always highly uncertain. Remember that Federal Reserve chairman Alan Greenspan declared that there was "irrational exuberance" in the stock market as early as 1996. The US stock market bubble, however, did not burst until four years later. Even today, US stock market indices remain above their levels in 1996.

Therefore, with ample capital inflows at the moment, countries like the United States can sustain their deficits and maintain low interest rates at the same time for quite a while more.

Certainly, as The Economist pointed out, central banks play an important role in keeping interest rates low. That includes the Federal Reserve. In fact, by keeping the federal funds rate substantially below the inflation rate until recently, the Federal Reserve has played a key role in keeping long-term bond yields low.

There is no secret to this phenomenon. The federal funds rate directly affects the cost of short-term funds, that is, short-term interest rates. The cost of short-term funds obviously affects the cost of long-term funds, that is, long-term interest rates. When short rates fall far below long rates, arbitrageurs swoop in, borrowing at the short rate and lending at the long rate, which tends to close the gap and push the long rate down.

When the Federal Reserve started its interest rate hikes in June last year, the spread between the 10-year Treasury note and the federal funds rate was well over 300 basis points. That is far above its average over the previous 50 years of below 100 basis points. Such a spread might be sustainable in a powerfully-expanding economy, but not at the mature stage of the cycle that the economy is now in where growth is expected to moderate.

The spread has since fallen, partly due to a rise in the federal funds rate, but partly also due to a fall in the 10-year yield as the outlook for economic growth moderated (see "Outlook for stocks and bonds may depend on PMI").

Alan Greenspan has called the fall in long-term rates a "conundrum". But it is partly of his own making. The slow or -- in the Federal Reserve's own words -- measured pace of rate hikes has surely been a factor. A slow rate of Federal Reserve hikes in the presence of a large spread between the 10-year yield and the federal funds rate has historically not been conducive to increases in the former.

The following chart shows how, over each of the 50 years from 1955 to 2004, the change in the 10-year Treasury yield (shown on the vertical axis) has varied with the difference between the change in the federal funds rate and the spread at the beginning of each year (shown on the horizontal axis).


From the above chart, it can be seen that, over the course of a year, when the increase in the federal funds rate has fallen well short of the spread (reflected as a data point well to the left side of the chart), the 10-year yield has often fallen in that year. In other words, if the federal funds rate cannot come up to the 10-year yield, the 10-year yield will come down to it.

Since the start of its rate hikes a little over a year ago, the Federal Reserve has raised the target federal funds rate by 250 basis points, well short of the spread at the beginning of its rate hikes. Little wonder that long-term rates have fallen.

However, with the spread between the 10-year yield and the federal funds rate now at about 70 basis points, a few more rate hikes by the Federal Reserve should see the former finally start to respond in the desired direction -- that is, up. Unless, of course, the economy weakens more than expected.

In any case, the upshot of this is that while the market may not be doing a very good job at moving interest rates in the direction required to correct long-term global imbalances, its behaviour has not, in fact, been very different from its historical pattern.

(Update on 13 February 2006: Corrects error on the spread at the start of interest rate hikes.)

US saving deficit leads to trade deficit

The US trade deficit in June was near record levels. Considering that oil prices and US consumer spending were at record levels in June, this was not exactly unexpected. Consumer spending's rising share of the US GDP in particular -- and its corollary, a declining personal saving rate -- has been a major driver of the expanding US trade deficit in the past several years.

On 12 August, the US Commerce Department reported that the US trade deficit for June was US$58.8 billion on a seasonally-adjusted basis. That is the second highest monthly deficit in 2005 and the third highest on record.

The record oil prices in June, when NYMEX crude oil futures broke through US$60 a barrel, was a major contributor to the increase in the deficit. Petroleum imports hit a record US$19.9 billion as imported crude oil prices in June averaged US$44.40 a barrel.

However, non-petroleum imports were also very high. The June figure of US$45.0 billion was the second highest on record.

The reality is that US consumer spending is at very high levels, and high overall imports largely reflect this fact.

Earlier, on 2 August, the Commerce Department had possibly given a taste of what was to come in the trade report when it reported that personal consumption expenditures for June had hit a seasonally-adjusted annual rate of US$8,723.5 billion, the highest on record and close to all-time highs even as a percentage of GDP. As a result, the personal saving rate for the month dropped to zero percent.

The fall in the personal saving rate to zero can be considered a milestone event. It is part of a longer decline in the US personal saving rate that began in the 1980s, as the following table illustrates.

	Average personal saving rate %
1961 - 1970	8.5
1971 - 1980	9.6
1981 - 1990	8.7
1991 - 2000	4.7
2001 - 2005 (June)	1.8

There are several reasons given by economists for the fall in the personal saving rate.

One explanation involves the "wealth effect". Rising asset prices -- in stocks for the past two decades or so until arrested in 2000, and in housing more recently -- caused Americans to feel wealthy and feel more able to spend.

Another explanation is the rise in labour productivity since the 1990s. With persistent productivity increases, Americans became more confident of continually rising income, encouraging them to spend more.

A third explanation is that innovations in finance has given Americans increased access to credit, which enables them to increase spending.

A fourth explanation is the fall in interest rates over the past two decades or so. Together with money illusion, it makes people think that they are getting lower returns on saving and incurring lower cost in using credit, thus discouraging them from saving and encouraging them to use credit instead. Lower interest rates also feed into higher asset prices and reinforce the wealth effect.

Whatever the reason, if the saving rate continues to decline into negative territory, consumer spending will very likely take an increasing share of GDP, and that must translate to a rising trade deficit unless other components of the GDP -- investment and government spending -- are sacrificed. As it is, the past years' rise in consumer spending and concomitant fall in the personal saving rate has contributed to a rise in the trade deficit from an average of 1.5 percent of GDP from 1991 to 2000 to 4.5 percent thereafter.

Common sense tells us that the personal saving rate cannot keep falling and the trade deficit cannot keep rising indefinitely. Eventually, Americans will run out of personal wealth and national assets.

How can investors position themselves for the eventual reversal in trends? Here are a few ideas.

A reversal of the falling saving rate implies a reduction in consumer spending and a probable slowdown in growth, even possibly a recession. This suggests a move out of equities.

A reversal of the rising trade deficit implies a weaker US dollar. This suggests a move into foreign assets.

Both might be associated with higher interest rates, at least initially, which suggests a move out of bonds.

The problem is that while common sense tells us that there will eventually be a reversal in the trends, it does not tell us exactly when that will take place. The United States is big and rich enough relative to other countries to be able to afford to run down its wealth for a long time.

A rise in interest rates might be the signal of an impending reversal in consumer spending. In this regard, the Federal Reserve seems willing enough to lend a helping hand. It certainly has been reversing its loose monetary. On 9 August, the Federal Reserve raised its target for the federal funds rate by 25 basis points to 3.5 percent, its tenth such hike since June last year. It also released a statement simultaneously suggesting that it would continue do so for at least a while more.

Having said that, longer term interest rates -- the ones that matter to consumers -- have stayed stubbornly low despite the Federal Reserve's persistent raising of the federal funds rate. Instead, the rate hikes appear to be attracting capital into the US and boosting the US dollar, hardly a recipe for correcting the trade deficit.

So investors who position themselves now for the eventual reversal of the declining saving rate and rising trade deficit might have to be very patient.

Stocks fly in July

The Singapore stock market had a good July, shaking off not one but two terrorist incidents in London to hit new five-and-a-half-year highs. And there are no compelling reasons why the good run cannot continue in the medium term. The long-term trend, however, suggests a limit to the upside.

The Straits Times Index (STI) gained 6.3 percent in July, closing on the last trading day of the month at 2,352.56, the highest close since January 2000, the month in which the previous bull market peaked. The two bombing incidents in London and the potentially crucial introduction of a new regime for the Chinese renminbi hardly made an impact on the stock market.

The Singapore stock market had good company in its optimism. The following table shows that all major stock markets rose in July. In Asia, the South Korean market, as represented by the KOSPI, did even better than Singapore's, rising 10.2 percent and hitting a decade high in the process.

	30 June close	29 July close	Percent change
S&P 500	1,191.33	1,234.18	3.6
Nikkei 225	11,584.01	11,899.60	2.7
FTSE 100	5,113.20	5,282.30	3.3
DAX	4,586.28	4,886.50	6.5
CAC 40	4,229.35	4,451.74	5.3
Hang Seng	14,201.06	14,880.98	4.8
KOSPI	1,008.16	1,111.29	10.2

Global stock markets have no doubt been supported by the recent spate of good economic news.

The US economy, the engine of world economic growth, grew 3.4 percent in the second quarter. Although this was slower than the 3.8 percent in the first quarter, it was marked by healthy growth in both consumer and business spending. Excess business inventories were drawn down. Price pressures moderated.

Forward-looking indicators have also looked good recently. The Conference Board's US leading index and the Chicago Purchasing Mangers' Index rose in June and July respectively. US home sales and durable goods orders for June also increased. US consumer confidence indicators moderated in July, though.

Perhaps more importantly, the positive news flow has spread to the rest of the world. Last week saw reports of both Japan's NTC Research/Nomura/JMMA Purchasing Managers' Index and Germany's Ifo business climate index rising in July, adding to earlier evidence that these two major world economies may be seeing a significant upturn.

Most importantly from the Singapore stock market's point of view, the Singapore economy has also been looking better recently. On a seasonally-adjusted annualised basis, real GDP expanded by 12.3 per cent in the second quarter, reversing the 5.5 percent contraction in the first quarter. June in particular saw turnarounds in Singapore's manufacturing output and exports, which rose 9.2 percent and 1.3 percent respectively. Non-oil retained imports of intermediate goods, a short term leading indicator of overall manufacturing activities, rose a strong 11.3 percent in June.

An announcement by the Singapore government on 19 July that it was easing rules on property financing and foreign home ownership also boosted market sentiment, especially in property and finance stocks.

Valuation-wise, the Singapore market is probably trading at a price-earnings ratio of about 16 based on 2005 earnings. It is not particularly cheap, but not high enough to suggest that low interest rates and momentum cannot bring it substantially higher.

And yet, it is important to remember that this bull cycle is already more than two years old. At this stage of the cycle, with the market looking at a likely moderation in the economy and corporate earnings growth in 2006, it is prudent to at least have an idea where the market is likely to peak.

As I have mentioned in previous commentaries, when the stock market last peaked in 2000, the STI had initially found support at around 2,000. Rebounds from that level had found resistance at around 2,200. Earlier, I had considered the possibility that the current cycle would peak between these two levels. However, after struggling for much of this year with the 2,200 level, the STI has now broken convincingly above it, so this target is obviously no longer valid.

Beyond 2,200, I see no obvious target for the STI. In last week's issue of The Edge Singapore, Goola Warden suggested a target of 2,400. To which I say: why not 2,583, the level of the last peak? This seems a more natural target to me.

This means that there is potential for the STI to rise over 200 points or almost 10 percent. Mature bull market or not, nimble traders may still fancy their chances in trying to eke out more gains on the long side.

However, if the longer-term trend holds, the STI may have trouble breaking its previous high in this cycle. Because for all its impressive showing over the past two years, over the longer-term, the Singapore stock market has looked more like it is in a secular bear market rather than a secular bull market.


The above chart shows the STI since 1993. In terms of its raw numbers, the STI has looked, at best, as if it has been going sideways. If adjusted for changes in the US$/Sing$ exchange rate or CPI inflation, the trend for the STI, if anything, looks worse. While the raw STI hit its highest level in early 2000, the exchange-rate-adjusted and inflation-adjusted STIs reached their highest levels in 1996 and 1994 respectively, and despite subsequent peaks, have not recovered those highs.

Looked at from these perspectives, one could quite plausibly argue that the Singapore stock market has been in a secular bear market for the last decade or so. The July surge notwithstanding, who is willing to bet that this is about to change?