Keep a close eye on inflation and the US consumer

Trevor Greetham, Asset Allocation Director at Fidelity International, discusses the outlook for markets in 2007.

2006: A Year of Transition

At the start of the year financial markets were at the tail end of two years of the global economy overheating. Growth was strong, inflation was rising and the US Federal Reserve (Fed) was increasing rates. Emerging-market equities and commodities were generating strong returns while bonds were struggling. Then in May, stock markets corrected sharply as investors focused on rising inflation pressures and evidence mounted that 17 successive increases in US rates were taking their toll and the US housing market was coming rapidly off the boil.

As we approach the end of the year, evidence of slower US growth is accumulating and a one quarter fall in the price of oil hints at a possible peak in inflation. The initial reaction from stocks to a possible peak in US rates has been positive. Bond markets have also performed strongly on the news, as should be expected.

Global themes for 2007

Lead indicators for growth are weak but most central banks are still raising rates. The world economy is likely to slow in 2007 with inflation moving sideways or downwards. Core inflation in the US is still creeping higher and thisis of some concern to the Fed but as it tends to follow headline inflation it will probably also ease off before too long.

I believe that a back drop of slower global growth and falling inflation favours global bonds overstocks and commodities. It also favours the more defensive developed market sover Asian and emerging-market equities. In global sector terms, I believe interest rate-sensitive consumer stocks and financials will fair better than cyclical industrial and technology sectors.

Equities:

In our view there are the two key questions for 2007: Will a weak housing market force the US consumer to slow and restore a positive savings rate? And will US inflation be sufficiently well behaved for the Fed to cut rates?

US consumer strength has been a major driving force for global economic growth and has acted as a power supply for the rapid economic development of China and other emerging markets in recent years. With US house prices falling, fears of weaker US consumer demand and a fall in business confidence could become more prevalent. For a soft landing in the US and world economy we probably need to see significant rate cuts from the Fed and lower mortgage rates. This, in turn, hinges on the path of inflation.

US equities have under performed the more volatile growth-sensitive markets for the last few years. It is ironic that the apparent global slowdown is US led but will probably make Wall Street increasingly appealing to global investors.

The Bank of England lifted interest rates by 0.25 per cent to a five-year high of 5 per cent in November, following evidence of stronger economic growth and investors expect one more rate increase next year. However, rises may be capped by the outlook for global growth amid an economic slowdown in the US. Historically UK stocks, like their US counterparts, have been relatively defensive in times of global weakness.

At present, European markets look most attractive. Growth remains strong, the ECB is relatively early in its rate rise cycle and the strength of domestic demand should help to offset possible weakness in exports. Euro strength also enhances returns.

Japan is probably the most susceptible major economy to a slowdown in US economic growth. The Bank of Japan officially ended its zero-interest rate policy with a 0.25 per cent interest rate increase in July. Any further tightening of monetary policy ought to be a delicate process following such an extended period of deflation. However, official statements seem to suggest a desire to "normalise" rates at around 3 per cent. In a slowing world economy, this stance may be weighing on equity market sentiment.

Smaller Asian markets have performed strongly. After very strong performance in 2005, the Korean market has slowed this year as a result of weakening business confidence amid political uncertainties and lower domestic consumption. However, the economic outlook remains positive, given the strong export growth and stable demand. Domestic demand in Taiwan has been impacted negatively by weak fixed investment and private consumption, although, looking forward, continued robust export growth should support the economy.

The main emerging markets of China, Brazil and India – which together represent around a quarter of global growth in recent years - should make an increasingly important contribution in the long-term. Weakness in developed economies, however, is likely to have a negative impact on investor sentiment.

Fixed Income:

While the last couple of years have been a challenging time for global bond investors, the outlook for 2007 is positive. If the plunge in homebuilder confidence in US translates into the bleakest forecasts being made about the US housing market, then US Treasuries and global bonds could do well.

A more likely gradual slowdown in global growth and a focus from central banks to control inflation should buoy fixed income markets over the next year. Although credit fundamentals remain strong, some deterioration may occur during 2007, but with a marginal rather than a wholesale weakening of the corporate environment. This could lead to an increase in the number of companies defaulting on loans, although it is important to note that this would be from low levels.

Property:

The global property market performed well in 2006, as a result of key drivers that should continue to underpin the market throughout 2007. Firstly, there is increased global demand for income-producing assets, of which property securities are among the highest yielding. Demographic trends are boosting this appetite for income and should continue to drive demand.

Secondly, we have seen a heightened awareness of the diversification benefits of property and property-related securities in recent years.

The arrival of Real Estate Investment Trust (REIT) structures in the UK and Germany in 2007 has already generated intense interest, although to a certain extent, many companies have already had this factored into their share prices.