Fixed Income Update

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Fixed Interest
Global Economic and Market Outlook
August 2004

Global Economics

US

Recent labour market data has fallen short of expectations, and investors' concerns about the economic recovery's sustainability have resurfaced. However, further evidence of a slowdown is needed for us to modify our growth and interest-rate expectations. The Federal Reserve, believing the pause will only be temporary, raised interest rates by 0.25% to 1.50% and reasserted its intention to continue doing so at a 'measured' pace. Its conundrum is that, unless it continues to raise interest rates (which are still a long way below neutral), it will lack its key tool to stimulate growth in the case of a more prolonged slowdown. Record-high oil prices could become a greater concern, although it is unclear whether they would hurt growth (if companies are unable to pass along higher costs to consumers) or drive up inflation (if they are).

Europe

European growth is expected to reach 1.8% in 2004. Poor demographic trends, persistent unemployment and accelerating inflation (mainly through higher commodity prices) are unlikely to revive consumer spending. On a brighter note, stronger global growth is boosting export volumes and prices, despite the stronger euro. The European Central Bank is determined to keep monetary policy relatively tight, claiming that the region's economy will continue to recover in the second half of the year. It has also cited higher energy prices as a potential risk to inflation.

UK

The UK economy is expected to grow by 3.5% this year, a marked improvement over 2003 and the fastest annual rate in almost four years. With little excess capacity (especially in the labour market) and inflation expected to reach the Bank of England's 2% inflation target within two years, the Monetary Policy Committee raised interest rates by another 0.25% to 4.75% in early August, its fifth hike since November last year. This rate-tightening cycle is drawing to an end; however, with another two or three 0.25% increases to come, the recent market rally - driven by the disappointing economic data in the US - has been premature.

Japan

Japan was the fastest-growing, G7 economy, as key government policies - low interest rates, intervention in the currency markets (to halt the yen's appreciation) and financial system stability - appeared to be having the desired effect. However, second-quarter GDP of just 1.7% was well below expectations - both investment spending and consumption were disappointing - raising concerns that the recovery is losing momentum. Furthermore, China, which is Japan's second-largest export market, has introduced measures to slow down growth, and this could dent future orders. Reiterating their confidence in the country's economic prospects, Japanese officials have been preparing investors for an eventual end to quantitative easing and the zero interest-rate policy. But the Bank of Japan, keen to avoid repeating its previous mistake of tightening monetary policy too early and thwarting growth, is willing to be patient.

Currencies

PPP-based valuation frameworks highlight that sterling and the US dollar are expensive compared to other currencies; the Canadian dollar and the yen are especially cheap, while the euro appears fairly valued. Sterling and the Australian and New Zealand dollars could be vulnerable once investors' interest-rate expectations have peaked. The US dollar could rally in response to higher interest rates, although any strength should be limited unless the country's fiscal and current account deficits are reined in. However, currencies are unlikely to move in any clear direction in the short term, providing a frustrating environment for exploiting investment opportunities. We have sold sterling and US dollars in favour of the euro, and further reduced our exposure to sterling in favour of the Canadian dollar.

Government bonds

Geographically, we favour Europe, where the economic outlook is relatively subdued and interest-rate increases are lagging. We retain short-duration strategies across all major markets, risk-managing them as necessary, as we believe interest rates - and bond yields - will rise in the medium term in response to sustained global growth and higher interest rates. However, the recent fall in bond yields means our targets may be lower than we originally anticipated. We anticipate closing our underweight position in the UK, which will be the first market where the interest-rate tightening cycle is drawing to an end.

Tim Swadling
Investment Director,
Fixed Interest Henderson Global Investors (Singapore) Limited