the global outlook

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    Caution: This is crystal ball gazing at an extreme level (and using rose coloured lens):

    Investors facing sea change when Fed stops hiking
    Wed Nov 16, 2005 12:02 PM ET
    By Jeremy Gaunt, European Investment Correspondent

    LONDON (Reuters) - The end of the Federal Reserve's rate tightening cycle, when it comes, is shaping up to be a tipping point for big money investors, possibly boosting U.S. stocks, and easing pressure on bonds.

    It could also reignite the dollar's decline by removing one of the main reasons for its recent strength.

    All three moves would have significant impacts on investment in Europe and elsewhere, with a stronger euro hurting euro zone company competitiveness and more attractive U.S. assets draining domestic and foreign money from abroad.

    Some appetite for U.S. assets has already been rekindled this month, although for the most part large investors are still keeping their exposure to U.S. stocks and bonds relatively low.

    In its latest fund manager survey, for example, investment bank Merrill Lynch found that global investors are clearly bullish about equities as a whole but that a significant majority is negative about U.S. stocks.

    The S&P 500 <.SPX> has gained around 1.5 percent in the year to date compared with nearly 18 percent for Europe's FTSEurofirst 500 <.FTEU> and even more in Japan.

    But the same survey -- noting that "the darkest hour is before the dawn" -- suggested that some investors were gearing up for a return to U.S. markets.

    It reported a jump for the second month in a row in the number of investors who say they are planning to add exposure to U.S. equities.

    In a similar vein, Reuters asset allocation poll taken at the end of October showed U.S. and continental investors raising their holdings of U.S. stocks and bonds.

    All this has been reflected on financial markets. In the month to date, it is the previously poor-performing Nasdaq <.IXIC> that has been a leader among major stock indexes, racking up around 3.5 percent in gains compared with some 2 percent for the FTSEurofirst and 2.2 percent for Japan's Nikkei


    The spread between yields on the 10-year Treasury bond yield and the Bund has tightened in the month, with the latter underperforming.

    The dollar has galloped ahead, leaving the euro down nearly 3 percent .


    It remains to be seen whether this mini-love affair with U.S. assets -- perhaps simply a reaction to the poor performances in October -- continues.

    But there is little doubt that the eventual ending of the Fed's tightening cycle -- generally expected in the middle of next year -- will have a significant impact on investor strategies on a host of investments.

    U.S. equities, for example, could get a fillip once the headwinds of higher rates dissipate.

    "Long term, we are bullish (on U.S. equities) because earnings prospects are solid and we expect the Fed will complete its tightening program between 4.50 percent and 4.75 percent by mid-2006," wealth manager Citigroup Private Bank told its clients this week.

    "Stocks historically tend to perform well once the Fed stop raising rates."

    But the caveat from the bank and others is that it all depends on why the Fed stops hiking. If it is because inflation is benign as growth continues, then equities should benefit.

    If, on the other hand, the Fed is forced to stop because of slumping growth, stocks would become buffetted by new headwinds.

    The dynamic facing U.S. Treasuries would also change, with a Fed halt, particularly if inflation is under control.

    Bond yields have backed up in the cycle to more than 4.5 percent, making them at the very least a better deal than they were, even if they may still present investment risks.

    "Value is starting to return in the market but yields have the scope to go higher," said David Shairp, global strategist at JP Morgan Asset Management. "There is a lot less downside to the U.S. bond market than there was three or four months ago."

    The impact on U.S. bonds of the end of Fed tightening could be exacerbated if, as expected, the European Central Bank begins its own policy of raising rates.

    Bond investors could jump from the euro zone to the United States, as recent yield performances have suggested.


    The dollar, meanwhile, has been rising sharply against many major currencies, particularly the euro, after a three year tumble. The spurt is widely put down to the rate differential between the United States and the euro zone, currently two percentage points.

    That would change if the Fed stopped hiking and the ECB began, although the spread is likely to widen before this point is reached.

    Most significantly, many investors argue that the differential is a cyclical factor that is masking fundamental structural imbalances that should weaken the dollar, notably the large U.S. current account deficit.

    The mask could be removed at the end-of-tightening point.

    Recent Reuters polls of both fund managers and currency strategists, for example, indicated that expectations were high that the dollar will begin to weaken again against the euro next year as the Fed stops raising rates.

    "The end of the tightening cycle will bring fundamentals back into play," said Klaus Wiener, chief economist at AMB Generali Asset Managers.

    The rub would be that this could boost U.S. competitiveness and weigh on the euro zone just as the latter was facing its own shift in monetary policy.
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