Global Markets: Economic And Strategy Themes

The slowdown in the American economy could see both oil and gold rising again in the next year even as the benign backdrop for US interest rates acts as natural nirvana for emerging market shares

It is now obvious that the American economic supertanker has lost its momentum as housing starts and building permits plummet, and the construction sector’s woes continue to deepen. This means that GDP growth, which slowed dramatically all summer to 1.6 per cent in Q3, will remain anaemic in 2007. Apart from housing, the production declines in Detroit mean that the auto industry will be a drag on GDP growth. The American slowdown is reflected in the US$20 fall in crude oil prices, the new bearish trend in copper (almost half of US copper demand derives from residential housing growth, which is in deep peril) and, above all, interest rates. Note that the yield on the bellwether 10-year Treasury note peaked in June at 5.22 per cent (a month ahead of US$78 oil, not coincidentally!) and the price of money in Uncle Sam’s IOUs has now fallen to 4.6 per cent. This dramatic fall in oil prices and interest rates was a valuation steroid shot for large cap American shares. Hence, the unexpected, strong bull market that has led the Dow, the S&P500 index and NASDAQ higher by 12-15 per cent in a mere four months.

It is, of course, axiomatic that inflation peaks follow economic slowdowns, so a rate hike is not at all a probable scenario. In fact, if GDP growth is 2 per cent, the Bernanke Fed may well be tempted to do a policy U-turn and begin its first rate cut. In any case, I believe the 5-year Treasury note can fall 200 basis points, as the 10-year yield falls to 4 per cent. The world’s central banks, led by the Peoples Bank of China, the Bank of Japan, the Russian Central Bank and SAMA, are now holders of a trillion-dollar hoard in US Treasury securities. While Asian central banks may increase their holdings of euro, British pound and sterling at the margin, there is no credible alternative to the greenback given the scale of central bank reserve accumulation necessitated by the US current account deficit and the Chinese as well as Arab Gulf foreign exchange pegs to the dollar. A slowing American economy will also dampen the hawkish tightening instincts of the Bank of Japan and the ECB, postponing monetary tightening and enabling the dollar to fall gently against the world’s Eurocurrencies.

What are the implications of the above scenario in the financial markets? One, American interest rates will continue to decline. Two, gold could well rise to US$680 or even challenge May’s high against the dollar. Three, the dollar fall will be particularly marked against the euro. Jean Claude Trichet’s ECB will inevitably raise interest rates by 50 basis points as long as Euro zone GDP accelerates to 2 per cent amid wage increases and persistently rapid growth in the money supply. Four, the bullish zeitgeist for American, European and emerging markets equities will continue. After all, if US$87 per share earnings on the S&P500 index is assumed, Wall Street trades at a valuation of 16 times earnings. This valuation is not excessive at a time of strong profit margins, liquid balance sheets, M&A mania, dividend increases and share buybacks.

The European stock markets offer the best combination of value and growth, particularly in Switzerland, Germany and Britain. Moreover, it appears as if higher beta technology and financials will lead the rally, as they have done on Wall Street since July. It is extremely unwise to underestimate the power of hot money and improved fundamentals to turbo charge the market cap of even the megacap shares on the NYSE and NASDAQ. So Cisco rose from 19 to 27 in the last six months. Goldman Sachs rose from 138 to 195 in the same time. Microsoft has risen from 22 to 29. Since the current bull cycle in global shares began in 2000, Russia’s RTX index has soared from 200 to 1700. A benign backdrop for American interest rates is naturally nirvana for emerging market shares. Note Hong Kong, Mexico and Brazil, three emerging markets highly correlated to the 10-year T-bonds breakout since July.

The year 2006 will go down in history as an annus horribilis for GCC stock indices, particularly Saudi Arabia’s Tadawul and UAE’s DFM, which fell by 50 per cent and 62 per cent from their respective highs. It is still too early to bottom fish in the GCC share markets though Omani banks, Kuwaiti telecoms and UAE property financier (Tamweel) offer excellent value at current levels, particularly as lower dollar interest rates assist its product rollout and market share. Japan has emerged from its deflation spiral and “lost decade”, EU growth was actually higher than the US in H2 2006 and India and China GDP growth will actually accelerate.

So, I doubt if we will see a bear market in oil. The Kremlin’s hawkishness on mega contracts with Shell and Exxon on Sakhalin means that Putin is determined to use the threat of government intimidation to promote Russian energy interests. Nor do Saudi Arabia and OPEC have any incentive on quota cheating or a bear spiral in oil prices. The world is still operating on a tight two million barrels in spare production capacity and the risks of either a supply shock or geopolitical flare-ups are not reflected in US$55 a barrel crude oil. In fact, as the endgame of the Putin era approaches with the Duma and presidential election, crude oil may well incorporate a US$10 Russian supply shock premium. It is therefore not inconceivable that oil prices may rise to US$70 in the next 12 months.

Matein Khalid is a renowned investment banker based in Dubai. His regular monthly column focuses on the economic happenings in the Gulf Cooperation Council member countries and their impact on the global finance.

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