Stocks fall as Fed raises rates and jobs data disappoint

5 July 2004

Stock markets around the world fell last week after the Fed raised interest rates by 25 basis points on Wednesday and a US Labor Department report showed that American companies created 112,000 jobs last month, less than half what economists had expected, raising fears that the US economy may be slowing down.

In US markets, the Standard & Poor's 500 Index dropped 0.8 percent to 1125.38 for the week, its third consecutive decline. The Dow Jones Industrial Average fell 0.9 percent to 10,282.83, its second weekly fall. The Nasdaq Composite Index declined 0.9 percent to 2006.66, its second weekly fall in three.

In Asia, the Morgan Stanley Capital International Asia-Pacific Index declined 0.5 percent, its second weekly loss in three. South Korea's Kospi fell 3 percent while Japan's Nikkei 225 Stock Average slid 0.5 percent.

In Europe, the Dow Jones Stoxx 50 Index shed 2.2 percent last week. Energy stocks led the way down, followed by non-cyclicals.

So much for the much-anticipated summer rally. Instead, it looks to me like stock markets may be resuming their correction.

For the second half of 2004 as a whole, however, I still think there is a good chance that we will see a gain for most markets.

The US labour market notwithstanding, the global economy remains strong. In the US, the Institute for Supply Management (ISM) index, a compilation of responses from purchasing managers that provides an indication of manufacturing activity, stayed strong at 61.1 in June, near a 20-year high.

In Singapore, the purchasing managers index (PMI), a similar index compiled by the Singapore Institute of Purchasing and Materials Management, rose to a 44- month high of 56.8 in June.

In Japan, the tankan survey showed Japanese companies to be increasingly confident about business conditions. The diffusion index (DI) for large manufacturers hit plus 22 last month, its highest reading since August 1991. The DI for small manufacturers rose to plus two, its first positive reading since November 1991.

Non-manufacturers also reported improvements. The DI for large non- manufacturers rose to plus nine from plus five in the previous quarter, while small non-manufacturers rose to minus 18 from minus 20.

Even Europe is seeing some economic resilience. Although European manufacturing slowed last month, with the purchasing managers' index in the Eurozone falling to 54.4 in June, it is still near its three-and-a-half year high in May of 54.7. And although Germany's Ifo index of business sentiment fell to 94.6 in June from 96.0 in May, Ifo Institute head Hans-Werner Sinn said that he still expected Germany to experience a moderate recovery later this year.

On 1 July, the European Central Bank decided to leave its main lending rate unchanged.

Stock markets are also likely to be supported by robust corporate earnings going forward. In the US, forecasts compiled by Thomson First Call indicate that second quarter profits for the 500 companies in the Standard & Poor's stock index rose 20.5 percent compared with the corresponding quarter last year.

Edward Yardeni, chief investment strategist for Prudential Equity, thinks investors have not paid sufficient attention to the strong corporate fundamentals.

"I believe that short-term concerns about interest rates, inflation, oil prices and Iraq have distracted investors from appreciating the amazing rebound in profits and cash flow," Yardeni wrote in a research note on 22 June. "They should also be very impressed by the health of corporate balance sheets. The market's P/E should rebound later this year, once investors see the light and stop staring into the dark."

However, a strong stock market rally -- if and when it does come -- is likely to be the last for quite a while. As I have mentioned before, the current bull market -- assuming it is still alive -- is probably just a rally in a secular bear market. It is a rally that has been made possible by loose fiscal and monetary policies in the US, policies which, as Stephen Roach, chief economist for Morgan Stanley, keeps reminding us, are exacerbating the twin deficits in the US and causing global imbalances that must eventually be corrected.

"There are no assurances that this transition [to a condition of balance] will be smooth or trouble-free," Roach wrote on 28 June in the Global Economic Forum. "At the same time, there are no guarantees that such rebalancing will end in crisis either. But on a risk-reward basis, the odds appear to be skewed more toward a hard- than a soft-landing, in my view."

So some time toward the end of this year or in the first half of next year, we are likely to see stock markets resume their longer-term decline in anticipation of a global economic slowdown,.

Felix Zulauf, president of Zulauf Asset Management, appears to think so too, based on what he said at Barron's 2004 Midyear Roundtable discussion.

"In the second half, growth will continue, but at a decelerating rate," he said. "Inflation rates will rise, but by less than expected. Short term interest rates will rise, also by less than expected. Monetary policy will remain expansive and stock markets will rally. But investors should sell into the rally because it will mark the cyclical top of the first bull market within a secular bear market."

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