From the December 2006 issue of Wealth Manager Web • Subscribe!

December 1, 2006

Global Ties

Americans have just finished tucking into their Thanksgiving turkeys with much to be thankful for as stock markets hovered near or exceeded record levels, and economic growth indicators gave signs of continued strength. Chief among those signs were the dramatic upward revision in U.S. employment figures indicating that more jobs had been created, and that the housing slowdown--dreaded as much in Stamford as in Stuttgart--has so far failed to knock down neither the U.S. economy nor the global.

The sharp drop in crude oil prices is also easing cost pressures on consumers and businesses around the world. Crude oil topped out at $78.40 a barrel on July 14 and through mid-October slumped 25 percent. Goldman Sachs estimates the drop in energy prices could boost disposable income by $90 billion. That shot of confidence heading into the holiday shopping season means the tryptophan haze of Thanksgiving turkey will burn away quickly.

All this makes it difficult for the U.S. Federal Reserve to lower interest rates. A stronger soft-landing scenario could mean the Fed holds the current benchmark lending rate at 5.25 percent. Talk of rate hikes is back on the plate as increased consumer spending would fuel inflation pressures, something the Fed will do its best to thwart. (Not everyone agrees, but more on that later.)

What transpires in the U.S. is usually felt in Europe, since America is still considered the engine driving the global economy. And while Europeans may not have had turkey on their plates in November, come Christmas their merriment is likely to rise along with interest rates. As Jean-Claude Trichet, president of the European Central Bank, told the European Parliament in early October: "Our monetary policy continues to be accommodative. If our assumptions and baseline scenarios are confirmed, it will remain warranted to further withdraw monetary accommodation." In other words, rates are going nowhere but up.

Economic growth in the euro zone rose 0.9 percent in the three months ended June 30 on a quarter-by-quarter basis. That was better than the United States, Japan and Britain and set the region up for its best year since 2000. As economic data indicated broader economic expansion, in Germany--the heart of the European economy--many were predicting interest rates, currently at 3.25 percent, could top 4 percent by the end of 2007.

"[ECB President] Trichet, delivered fairly hawkish testimony to the European Parliament..., signalling further rate hikes to come," said Michael Taylor of Lombard Street Research in London.

In Europe, the rise in interest rates coincides with greater consumer spending. Standard Life Investments, a global investment company, believes spending is improving, but patterns are distorted. Spending habits during the warm summer months may have boosted consumer spending, they caution, but the World Cup effect--while expected to bring about robust spending on electronics, especially flat screen televisions--is falling short of some analysts' estimates. German spending habits may also be showing false signs of strength ahead of January's Value Added Tax increase, because such moves typically shift forward spending decisions.

Still, one strategist believes there's more growth in European stocks as the dollar is likely to come under pressure. "European stocks are trading at less of a discount now, but we favor European stocks over U.S. stocks," said Mike Turner, head of global strategy at Aberdeen Asset Management in London.

And while the world frets about the U.S. housing market, Turner believes property-- particularly in the United Kingdom--still looks attractive, even as UK interest rates are expected to rise to at least 5 percent before yearend. Turner cited a 14.2 percent return for the year through September in the IPD Property Index--a measure of commercial property values--driven by pension funds and an influx of foreign cash, mainly from the Middle East. "We are coming toward the end of the boom, but this still works into 2007. If interest rates don't rise, then the performance is sustained," Turner added.

Too much property is one factor leading Merrill Lynch to dismiss the recent upturn in the U.S. economy and predict falling interest rates in the first quarter of 2007. A Merrill Lynch report noted the "weight of the most oversupplied residential market in recorded history" is going to exacerbate the negative impact of a decline in housing activity.

If the Fed stays on hold, rising interest rates in the euro zone and in emerging markets like Hungary, Turkey and South Africa will cause problems for the U.S. economy and perhaps trigger a hard landing as a slowing global economy moderates U.S. export growth. Will we see an economic role-reversal in the new year? After the turkey, Americans may need a longer nap.

Justin Daniels wrote about obscure indices in April.

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