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The world economy has remained strong and financial markets have now turned the spotlight on two main areas:
Inflation
While oil prices are off their highs, they are still firm. Gold, commonly used as a hedging instrument for inflation, has also risen in price. This shows that investors are getting more worried about global inflation risk.
Interest rate outlook
Central banks have warned of interest rate increases. The firming of short-term market rates are a sign that interest rates are likely to increase in the near future.
US Market
For the US market, we hold these views.
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Hold cash: Against the backdrop of global inflation risk and rising interest rates, the US Dollar (USD) has strengthened. Our recommendation to hold cash and not global fixed income is now more compelling. |
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Higher US interest rates: As the Fed has been issuing aggressive comments , we believe that they intend to raise interest rates until inflation is under control and economic growth is not stifled. Thus, they will probably not go for a rate hike pause in December. Ben Bernanke’s appointment as the new Federal Reserve Chairman only reinforces the existing policy direction.
We think that Fed rates will peak at 4.75% at the end of 1Q 2006. If the economy continues to deliver above-trend growth, the risk is skewed to more tightening beyond 1Q 2006. Substantially higher interest rates will put highly leveraged households in a more vulnerable position. However, the Fed's continued ‘measured’ approach should help to cushion some of the impact. |
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Interest rate hikes to affect global equities: Strong US economic performance has exceeded expectations, as there have been significant rate hikes. The prevailing growth momentum has fuelled the recent rebound in global equities. However, we believe that the markets have not factored in the impact and speed of next year’s interest rate hikes on the economy. |
Asian Markets
In Asia, a broad-based monetary tightening cycle is also underway.
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In Thailand and Indonesia , the tightening so far has been aggressive. This is likely to remain for a longer period of time as the impact of domestic fuel price hikes will be felt later. The current interest rate environment also allows more room for interest rate increases. |
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Malaysia is a clear example with inflation currently at 3.4% y/y and overnight policy rate at only 2.7%. There is a high chance that the Malaysian central bank will increase interest rates by 30 bp on 30 Nov when it releases its quarterly monetary policy statement. |
The need for higher interest rates in Asia could also be due to the recent strength of the USD. A higher USD-Asia is a stimulant. Those who cannot afford to support their currency at high levels could be forced to hike rates more aggressively to achieve the same desired tightening effect. Those who fail to catch up with the pace of Fed tightening could risk seeing hot money flowing out of the country.
In any case, a swift response from policy makers is required. Risks associated with Asia are bound to rise in 2006. With global risk appetite already at high levels, equities could take a hit as and when the markets start to price in more of such risks. |
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Bulls and Bears 
