January 2007

As we enter a new year, the assumptions that drove securities markets during the second half of 2006 are being tested. Whereas the consensus view predicts a gentle slowdown in the US, characterised by containable inflation, the most recent economic reports from the world?s largest economy have given the investment community food for thought.

US economic health is of paramount importance for the direction of financial markets world-wide. Currently, investors are having difficulty gauging US economic wellbeing, due to conflicting statistical reports. (Of particular significance in this regard is the impact on US monetary policy; there have been doubts as to whether the Federal Reserve has accurately assessed the direction the domestic economy is taking, although, given statistical evidence pointing variously in both directions, this is understandable).

The surprising strength of the most recent US payroll figures has caused some alarm, even among the optimists, and forced investors to scale back expectations of an early rate cut, which has been one factor underpinning equities of late. With a rate cut due to growth factors now looking less likely during the first half of 2007 than hitherto supposed, the case for equities rests largely on hopes for a rate cut due to moderating inflation, a prospect recently rendered more credible by renewed declines in crude oil and commodity prices. However, given the Fed’s persistent call for inflation vigilance, and barring an unexpected and dramatic fall in general price levels, such hopes would appear to be wishful thinking for now.

Contrarians, meanwhile, are less unfazed by the apparently buoyant labour market than one might assume, pointing to the housing slowdown in particular as a major, underestimated threat. While the signs so far suggest a soft landing for the housing market, doubters cite the impending glut of housing supply, indicated by the record number of residential units for sale and a boom in units under construction, as a matter of some concern going forward.

Another potential threat to market stability lies in the development of the US dollar. At present, markets are awash with liquidity, but this could evaporate if the greenback weakens severely, a possibility that should not be taken lightly. Should demand for the US currency diminish significantly, the likely result would be rising US interest rates, a slowing US economy and a pounding for both bonds and equities.

Whether or not such concerns are justifiable, they at least serve to prevent investors from becoming overly optimistic at a time when equity markets in particular look increasingly vulnerable to bad news.