Is the market volatility over?

Andrew Vaughan - Fri 30 Jun, 2006

...Last months dark days of slumping markets have yet to pass. Great shares at bargain prices now litter the global markets. But it would be wrong to say that it is party time again...

   
   
- Last month’s dark days of slumping markets have yet to pass. Great shares at bargain prices now litter the global markets. But it would be wrong to say that it is party time again.

- Two black clouds – of rising interest rates and slowing economic growth – remain on the horizon. Neither is worth obsessing over, however.

- Interest rates, like the tide, will always ebb and flow. All that investment markets require for their well-being is that interest rate policy be both sound and effectively communicated. And more important than GDP growth figures is the performance of individual companies.

- All that counts is our ability to predict demand for the products and services of selected companies. But here again at the moment, it is the uncertainty of direction that has sapped confidence and is depressing valuations.

- The chairman of the US Federal Reserve Ben Bernanke, has certainly stoked confusion with his off-the-cuff comments about rising inflation, driving Wall Street into another dive and taking the FTSE and most other stock markets down with it. The markets have been aware of inflationary pressures for some time. However, it is the manner in which US and European central banks will respond to inflation that seems to be changing.

- Maintaining growth – the aim behind the Fed’s low-interest rate policy following 9/11 and the Dot.com crash before it – now seems a lesser priority than curbing inflation. The result is higher interest rates ahead in the US. Meanwhile in Europe, and despite euro interest rates at 2.75% – almost half of the US dollar’s 5% rate – the IMF has warned against significant tightening.

- No wonder markets do not know which way to turn! Suddenly, global interest rates look set to rise – and the risk is that they will rise higher than they need to.

- But the inflationary threat is very real. Up until now, growing exports from China and India have resulted in falling prices for many goods in developed countries. These price falls counterbalanced rising energy and services costs, to keep average inflation figures benign.

- But take away the prop of cheap goods from Asia, and inflation figures move up sharply. This is what we saw in recent UK inflation data. The cost of clothing and footwear sold in British shops actually rose, instead of falling, from a year earlier in May. The average rate rose from 2.0% to 2.2% on the CPI – above the Bank of England’s target. That suggests higher UK interest rates ahead.

- What’s more, retail fuel prices were increased significantly in both India and China this month. And with their export markets now firmly established, cheap goods from Asia are set to get a whole lot more expensive.

- How to defend yourself? We continue to have strong affection for gold, oil and other real assets. Gold may have dropped sharply below $600 per oz, and UK-listed mining shares have suffered a 25% drop since mid-May. But behind the confusion over global interest rate policies, the risk of inflation is rising, not falling.

- Emerging markets are also bearing the brunt of this sudden fall in investor confidence. Turkish and Taiwanese equity markets and currencies have been particularly hit. A shining exception has been Shanghai, where the equity market continued to make new two-year highs until slipping back in the middle of this week.

- New records, meanwhile, have been set in Hong Kong. The IPO of Tianjin Port for HK$1bn was subscribed a mind-boggling 1,700 times over. That is an awful lot of cash, physically put on the table by investors. It bodes well for the long list of China IPOs waiting in the wings.

- Such confidence – on top of the successful flotation of Bank of China – would have been inconceivable during previous bouts of market jitters.


Regards,

Andrew Vaughan
for The Daily Reckoning