Expert View: The bulls should take a breather

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The Independent Online

The markets have started this year as they left off in 2003. Having priced out the war and the recession that never really was, they are now pricing in global growth. Equity markets are in a cyclical bull run as corporate profits recover sharply and commodities are flying as global demand recovers. However, having already hit our (admittedly not demanding) year-end targets, we feel equities are due a pause for breath.

Surprisingly, bonds are also doing well, but this is arguably more to do with the behaviour of central banks than of economic indicators. For, while economics is important in the long run, it is monetary policy and short rates that dominate bonds in the near term.

For example, the UK, where the latest GDP data came in above expectations, suggesting growth of 4 per cent, is seen as odds-on to raise interest rates from 3.75 per cent, whereas the US, where growth is running at an annualised rate more than double that in Britain, is expected to leave rates unchanged at a mere 1 per cent for the rest of the year. And the one thing most economists see preventing a rise by the Bank of England is the value of sterling - particularly against the dollar. Yet no one is suggesting the Federal Reserve raise rates to defend the greenback.

Even more confusing, a 1 per cent rise in interest rates has a far more powerful effect on British consumers than on their American counterparts, because of our (crazy) short-term mortgage rates, and yet the UK consumer is already facing higher taxes this year, while the US is looking forward to more tax cuts.

In part, it's because the UK monetary authorities have a single target - inflation - while the US also takes account of growth. The lesson here is that in predicting short rates - and by extension long rates - we have to look at what individual authorities are most likely to do - not what we want them to do.

Against this policy background, it's difficult to find a US investor wanting to buy into the UK markets - even if they hadn't just got 15 per cent more expensive because of the weak dollar. It's no coincidence that some of the best-performing UK stocks in recent months have been those most exposed to a global recovery rather than domestic growth.

And the big risk to markets this year? Perhaps that the Federal Reserve does, in fact, raise interest rates. After all, for all the obsession with economic drivers to interest rates, most of the recent moves in Fed funds - and by definition all the "surprises" - have occurred when the Fed has ignored the "rules" of the pundits. This is because, as well as inflation and growth, the Fed is required to maintain the stability of the financial markets. Thus, events such as the 1987 crash, the 1998 Russian bond crisis and 9/11, as well as periodic concerns over a credit crunch, have all been met with lower short rates.

The biggest threats to US financial stability are a function of the low level of interest rates. Known as carry trades, they involve speculative bubbles inflating as traders borrow cheaply from the Fed to buy US or European bonds. In the first instance, we get a bubble in the bond market - and despite all that growth, US bonds are trading below 4 per cent - and in the latter we get a sell-off in the dollar, and we know what's been happening there. Thus, in contrast to previous moves, the need to maintain financial stability may involve higher rather than lower rates.

None of this is meant to be alarmist. I still believe equities are in a bull trend. It's just that when everybody else apparently stops worrying, it's often a good time to start.

Mark Tinker is a director of Execution Stockbrokers.