By Bob Doll

THE US economic and financial environment remains troubled, but it is important to emphasise that the economy is still growing. It is doing better than might have been expected given the proliferation of negative shocks, but the growth outlook is at best mediocre, and the risks remain tilted to the downside.

Meanwhile, the credit system remains badly impaired, highlighted by the ongoing free fall in financial stocks. It is virtually impossible to judge when oil prices will suffer a meaningful decline, and there is no sign of an end to the bad news emanating from the housing and banking sectors. Strong corporate profits and still-robust levels of exports remain among the few bright spots in the economic picture, however, and have helped keep the economy from sinking into recession. Looking ahead, we believe the US economy will remain mired in a growth range of between zero per cent and 2 per cent.

A holding pattern for the Fed

On the inflation front, the rhetoric from the Federal Reserve and other central banks around the world indicates growing discomfort with inflation trends. After cutting rates by 0.25 per cent on April 30, the Fed fulfilled market expectations by holding its target rate at 2 per cent at its June policy meeting, although there was likely intense debate about the appropriate timing of tightening. The fed funds rate is at its current low level because of financial strains, not because of economic trends. As policy-makers grew increasingly concerned about inflation trends, the discussion in the marketplace shifted to timing the eventuality of rate hikes.

In our opinion, however, it is not reasonable to expect the Fed to raise rates when the financial sector is still under pressure and the economy faces significant downside risks. Thus, current market expectations of 50 and 100 basis-point rate hikes in the next six and 12 months, respectively, appear misguided. At the same time, it would take a serious worsening in economic and/or financial conditions to cause the Fed to ease further. Faced with the cross currents of inflation on one hand and financial strains on the other, we believe the Fed will opt to stay on the sidelines for at least several more months.

The oil outlook

There are some encouraging signs that the spike in oil prices may be on borrowed time. An easing of demand pressures is clearly underway in many developed economies, subsidies are being reduced in the developing world, and Saudi Arabia is promising to boost output. A drop in oil prices would be bullish for both stocks and bonds. The markets would likely revise down interest rate expectations as inflation fears recede, and stocks would rally. Although prices seem to have reached a choke point for the global economy, the supply/demand balance is still tight, and it would not take much in the way of supply disruptions to cause prices to move even higher. At present, it is clear that the current level of prices represents a major headwind for the global economy and markets, and reinforces the case for a cautious investment stance. While we continue to believe that oil prices are due for a correction (and the sooner the prices fall, the better), we do acknowledge that it is notoriously difficult to accurately predict where oil prices are headed.

Starting in mid-March, at the time of the Bear Stearns collapse, equity markets bounced around but generally moved upwards throughout most of April and May. As the second quarter drew to a close, however, stocks began plummeting in the face of climbing oil prices, concerns about inflation and lingering credit and financial market issues. For the quarter as a whole, US equity markets experienced sharp losses.

The Dow Jones Industrial Average, which suffered as a result of some high-profile losses from key components such as General Motors and Bank of America, fell 6.9 per cent or almost 1,000 points, to end the quarter at 11,350. The Dow is down 13.4 per cent for the year. The broader market averages fared somewhat better, with the S&P 500 losing 2.7 per cent to end the quarter at 1,280 (leaving it with an 11.9 per cent loss year to date) and the Nasdaq Composite eking out a small quarterly gain of 0.6 per cent to close at 2,292 (notching a 13.6 per cent loss for the year). The Russell 2000, an index of small-cap stocks, also managed to post a gain of 0.6 per cent for the quarter.

Most international equity markets registered losses for the quarter as well. Japan, where inflation has remained muted, was one of the few standouts, with its market posting a 7.6 per cent gain. European markets, which are combating financial problems and inflationary pressures, suffered losses, with German stocks off 1.8 per cent, French stocks down by 5.8 per cent and UK stocks losing 1.3 per cent. Emerging markets experienced mixed performance. Chinese stocks continued to lose ground, falling 21 per cent, and most other Asian markets also notched significant losses. Latin American markets continued to perform well, led by Brazilian stocks, which gained 6.6 per cent.

In fixed-income markets, the flight to quality that was so evident early in the year reversed course somewhat throughout the second quarter as investors sold off Treasuries. The yield on the 10-year Treasury, which began the quarter at 3.41 per cent, climbed up to the 4.20 per cent range in mid-June before declining to 3.97 per cent at the end of the quarter amid the sharp stock market sell-off. In this environment, the Lehman Brothers Aggregate Bond Index lost 1.0 per cent. Finally, cash investments, as represented by the three-month Treasury bill, returned 0.3 per cent for the quarter.

The outlook

We are not among those predicting a disaster scenario for the markets (such as surging inflation and/or a deep recession), but it remains to be seen whether economic and financial conditions will improve enough to warrant a more aggressive investment stance later this year. Key developments that would support a more positive environment include a sustained drop in oil prices, a moderation in the rate of decline in house prices, fiscal measures to ease the plight of homeowners and a further easing in credit market strains. In the absence of these developments, we prefer a more cautious approach. On the whole, our assessment of overall equity market prospects has not changed. We believe equities should outperform both bonds and cash over the coming year, but it will come via a grinding upturn in prices, not a powerful bull run. However, there is a good chance economic disappointment will keep the market under pressure in the near term. Within the market, we would still emphasise globally oriented sectors rather than those more dependent on domestic activity.

These remain challenging times for both investors and policy-makers. The unfortunate reality is that the US economy faces a protracted period of sub-par growth, which hardly sounds much more appealing than a sharp and short recession. In some ways, it may be even worse, as a long period of disappointing performance could have a lasting and corrosive effect on confidence. If businesses start to believe that a recovery is a long way off, they may decide to adopt tougher measures to control costs, including bigger cuts in employment and capital spending.

We want to again emphasise that we are not among those who expect a dire outcome for the economy and markets, but we also realise that there is not much of a case for taking the opposite extreme. It will take time to work through the aftermath of a major credit bubble bursting, and we cannot count on further significant help from the monetary authorities given the inflation situation.

Certainly, things would look a lot better if oil prices were to suffer a large drop, but that is far from assured. Crises always create opportunities, and the prices of some equities have fallen by enough to create excellent value by historical standards. Caution remains the order of the day, however, until some of the economic and financial headwinds diminish.

Bob Doll is a vice-chairman and director of BlackRock Investment Management. He is also chief investment officer for global equities.

This article was first published in The Business Times on Aug 6, 2008.

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