Looking past interest rate hikes

Equities will perform better once interest-rate jitters settle; earnings are what count now, says Citigroup AM.

Anthony Muh, regional head of investments at Citigroup Asset Management, believes economic growth will cool off at a sustainable rate rather than overheat and crash, setting the stage for relatively better performance in the equities markets.

He emphasizes that despite expectations of US short-term interest rates rising another 75bp to 100bp this year, his balanced funds are not underweight bonds, although his position has been defensive, holding short-duration securities. But the prospect of rising bond yields will also hurt equities. "So it's not the time to leave the bond markets," he says, particularly because cash returns are so low.

Rather, Citi is maintaining neutral positions, with the hope that the market's concerns about US Federal Reserve interest rate rises will gradually dissipate, to be followed by a growth environment. "When inflation and growth are balanced, equities will usually do well," Muh says.

Leading indicators of economic growth in the US and the G7 economies have peaked, but the US economy looks benign, so Muh feels a recession is unlikely. Problems remain, such as the very low savings rate, but household wealth is rising, a housing collapse seems unlikely and consumer credit growth no longer outstrips income, which suggests to Muh that while the US consumer may be losing steam, spending patterns will not implode, either.

Meanwhile inflation has returned and US businesses expect even higher prices. Throw in unexpectedly high oil prices and it appears to Muh that the US Fed funds rate has a long way to climb - from 1.25% now to a long-term neutral rate of 4% to 5%. European interest rates are also below what Citi and others calculate as a natural long-term rate. This will keep bond fund managers on the defensive, he says, but suggests steady economic growth.

He is less sanguine about Japan, which despite improved bank performance, shows no sign of lending growth. That means that since there is no real consumer demand or rising industrial investment, exports have been the only real story behind its recent upturn, particularly exports to Asia. And Asian, particularly Chinese, growth is slowing. Citi believes Japan's real GDP growth is set for 3.9% for 2004, but that this will fall to 1.8% in 2005.

Other G7 markets, however, should deliver steady, solid economic growth, and the Asian markets look favourable. Investment spending across the region remains well down from the rates achieved in the mid-1990s, suggesting it will rise. Moreover as China's economy slows, some Asian markets should benefit as foreign direct investment diversifies away.

The two drags are oil prices, which hurt all Asian economies - ironically, the worst hit is Indonesia, because it subsidizes domestic oil prices, Muh says - and China's unpredictable attempt to cool off. The lack of financial data and the constraints of a pegged currency make the outcome of this impossible to predict, Muh believes. The impact of these factors is inflation. Not headline inflation, Muh cautions. But because regional central banks are resisting letting their currencies appreciate, local profits have no other channel than property and financial markets, creating asset price inflation.

Nonetheless, Citi's GDP growth forecasts for the region ex-China are positive, even if the 2005 story will be less exciting. Muh suggests Southeast Asian markets may benefit from portfolio inflows as North Asian markets slow down.

Emerging market stocks are generally undervalued, particularly Korea's, which may not have an attractive economic story but could see markets turn quickly, and Singapore's, where fundamentals also look strong. Taiwan, Hong Kong and Indonesia are fair valued while China, Thailand and the Philippines look expensive.

Although interest rates and inflation are important gauges, Muh says the biggest question for global equities markets is earnings. For now, upward earnings revisions have held up, but Muh says they are hitting plateaus across markets. "Are we leaving what has been a nice environment?" he wonders, noting the number of credit rating downgrades outnumbers upgrades. "The marginal changes in earnings momentum will impact the markets."

This will overshadow interest-rate hikes. Unlike previous examples of sharp rate rises, such as in 1994 and 1999, the equities market has anticipated the current round of changes, and already priced them in. "If earnings hold up, the equity markets will look good once we get past this fear of expected Fed rate rises," Muh says.