Torn between recovery and rates

22. Feb. 2010

LONDON - A tug of war between evidence of a strong U.S. economic recovery and the prospect for higher interest rates is making investors slightly hesitant in allocating their cash significantly more into stocks.

The move away from safe-haven money market funds that started last year was gathering pace in the latest week as investors pulled another $37 billion out of money market funds.

But a surprise rise in the Federal Reserve's emergency lending rate on Thursday poured cold water on to world stocks, reminding investors that cheap cash which has fueled a boom in stocks and commodities since last year will not last forever.

Just as investors started to focus on a more favorable economic outlook in the United States backed by a slew of strong corporate earnings and troubles in the euro zone, the very thought of the higher cost of borrowing could scare them.

The Fed is keen to allay fears that the hike, first rate move since December 2008, would bring forward broader policy tightening, saying that borrowing costs in the economy would stay low.

Investors are aware that sooner or later benchmark U.S. interest rates would rise but first such move is not expected until November.

Reflecting that optimism, the benchmark MSCI world equity index is on track for posting a second consecutive weekly gain for the first time since November.

"The (post-Fed) reaction... has been to regard it is an early step of de facto monetary tightening. Although the prospect of higher rates will be viewed with trepidation by the markets, it is likely that the federal funds rate will remain on hold for some time yet," said Ted Scott, equity strategist at F&C Investments.

"The move does signify that the monetary authorities have increasing confidence in the recovery in the U.S. economy. For equities this is good news for dollar earners that suffered last year with its weakness."

The dollar hit 8-month highs against a basket of currencies on Friday

DEPLOYING CASH

Data from fund tracker EPFR shows investors used the proceeds from money market funds to invest $3.69 billion into global equity funds and $3.48 billion into bond funds.

U.S. equity funds fared best in dollar terms, absorbing a nine-week high of a net $3.14 billion, while European equity funds was the only major developed market group to post outflows -- of a net $303 million.

According to Thomson Reuters data, companies listed on the S&P 500 index posted quarterly earnings growth of a whopping 212.3 percent for the fourth quarter, after a contraction of 14.7 percent in the previous three months.

They are expected to post earnings growth of 36.9 percent in the first quarter and the double-digit expansion is set to continue for the rest of the year.

Of 82 percent of S&P firms that have reported their earnings so far, more than 70 percent outperformed consensus forecasts in the final three months of the year.

"The upward momentum in the U.S. economy appears to be building a critical mass - much more so than in Europe," Cyril Beuzit, global head of interest rate strategy at BNP Paribas, said in a note to clients.

"What's clear is that the debate at the Fed about the exit strategy is moving on. The unwinding of unconventional support is ongoing. But the conditions required to prompt a conventional tightening are still some way off."

MORE CLOUDS

Next week's euro zone data on business morale could reveal the scale of a shock from the debt crisis in Greece and other debt-laden peripheral countries -- another factor which is bugging investors.

Investec is keeping its "low conviction" equity overweight due to concerns over huge fiscal deficits despite upside potential.

"There is considerably more upside in risky assets in the medium term and the downside looks limited but we don't anticipate much from the first half of the year," said Max King, the firm's strategist.

Investec said a preliminary estimate of 19 percent earnings growth and a 6 percent revenue expansion in 2011 would bring the global price earnings ratio down to just below 12.

"It is probably too early for this to impact investors' attention and it is certainly not discounted in valuations but it does illustrate the basis for a significant rally later in the year after a dull first half," he said. A weekend meeting of Group of 20 finance chiefs in Korea may also rekindle risks to the financial sector from regulation.

At their last meeting in Scotland, Britain pressed the G20 to come up with a plan to make banks pay for any future bailouts. G20 ministers launched a new framework aimed at rebalancing the global economy. Mario Draghi, chairman of the Financial Stability Board -- tasked by the G20 to supervise on new financial regulation -- told Reuters in January that global regulators are working on proposals for a central agency to manage bank failures.
[Reuters]