Bulls and Bears Looking beyond the strong start By Kelvin Lau, Economist, Global Research   More Fed hikes to come The global economy staged a strong start for 2006. Despite growing concerns over a potential overheating in the housing market and the negative implications on consumer spending, US retail sales still managed to post astonishingly high growth of 2.3% month on month in January (on top of many other strong data). In his first official testimony to the Congress since taking over the Fed Chairmanship from Greenspan, Ben Bernanke presented a balanced, but overall upbeat, view on the US economy, while seeing more upside risks to inflation than downside risks as resource utilisation tightens. With Bernanke's testimony, the Fed released its latest economic projections - the Fed sees real GDP growth of "about 3.5%" for 2006, and 3-3.5% for 2007. Few would disagree these are pretty strong numbers still, despite the gradual moderating trend. Under such a backdrop, Fed expectations have been climbing. Back in late January, the July 06 Fed funds futures contact priced in a 0% chance of another rate hike beyond March 06. As of February 15, the same contact is now pricing in a 90% chance of another 25bp hike beyond Q1. In light of the strong start to 2006, and the remarks from Bernanke, we have fine-tuned our Fed view. We still see another 25bp hike in March (to 4.75%), but now expect another 25bp hike in Q2, which changes the peak in the Fed Funds Target Rate to 5.00% from 4.75%. Equities: Balancing the risk factors What we have seen of late, therefore, is a fall in cyclical risk (in terms of cyclically improving US economic performance) and a rise in interest rate risk (in terms of rising Fed expectations). These two forces pulled US equities in opposing directions, and volatility rose in tandem. Looking ahead, investors will keep a close eye on the incoming data, and based on them, the two risk factors will be consistently re-assessed. Given our latest set of Fed forecasts, chances are that the recent rise in interest rate expectations may have already run much of its course, and therefore cyclical positives could well prevail going forward. That said, we are still worried the markets are pricing in too much good news when we look beyond the rosy near-term picture, especially when the underlying trend is still for global growth to slowdown from H2 2006 onwards - so much so that the Fed could go for rate cuts by Q1 2007, in our view. Indeed, we have seen impressive Q4 corporate earnings results so far, despite disappointments from Intel, GM and Google. Nonetheless, we believe the sustainability of high corporate earnings growth will increasingly come under challenge in the coming quarters. On balance, we have retained our neutral weighting on US equities. Elsewhere, strong global growth has boosted the overall level of risk appetite. Together with the high level of global liquidity and well-supported commodity prices, emerging market equities like Brazil, Russia, India and China have performed exceptionally well so far this year. However, as we have long argued, how long such favourable factors will continue remains questionable, and the risk is for traditional global growth/commodity plays and the inherently more expensive indices to suffer first as and when global conditions deteriorate - something which, in our view, is probable beyond H1 2006. Japan and South Korea's negative year-to-date equity returns also reinforce our view that strong performance in 2005 does not automatically imply the same for 2006. We are, therefore, comfortable with our current neutral weighting on Japan equities and we have recently downgraded South Korea from overweight to neutral. As a result, within Emerging Asia, the only country we are overweight on now is Thailand. On top of cheap valuations and strong fundamentals, the Constitutional Court's recent ruling against an investigation on PM Thaksin should also help clear some of the overhanging political uncertainties. Bonds: Pending for an upgrade With two more Fed hikes on the cards and investors sitting on near record-high net speculative long positions in the 10Y US Treasury futures contract, there is every reason for us to retain our underweight weighting on global fixed income for now. However, the closer we are to the Fed rate peak, the more uncomfortable we are with such an assessment. At some point in 2006, possibly in late Q2/early Q3, we should see a compelling case for us to go neutral. Beyond that, US Treasury yields should gradually come off their peaks as we run up to the start of a new Fed easing cycle - we expect this to materialise in Q1 2007. There is therefore a high chance that we will have to go overweight on global fixed income sometime in late 2006. The exact timing for both phases of upgrade will of course depend on the upcoming data and the resulting swing in market sentiment. In any case, it is always good to look ahead and be prepared.