Bulls are dreaming if they think the rate-rise cycle is over

PUBLISHED : Wednesday, 11 January, 2006, 12:00am
UPDATED : Wednesday, 11 January, 2006, 12:00am

A week after Hong Kong's stock market ignited on hopes of an imminent end to US interest-rate rises, it is time for a reality check.

In just six days of trading so far this year, the Hang Seng Index has risen 4.66 per cent, more than it gained in the whole of last year. The increase is a welcome new year windfall for investors, but even though the market outlook remains broadly positive, stock market bulls should be warned that such spectacular gains are not going to continue throughout the year.

The first thing to remember is that, despite the euphoria, interest rates have not actually stopped rising yet. In the minutes of last month's meeting, which were released on Tuesday last week in Washington, the US Federal Reserve's key monetary policy committee only said that: 'The number of additional firming steps required probably would not be large.'

A lot of eager investors took that to mean there will be just one more quarter of a percentage point increase on January 31, and that the Fed would then hold tight, leaving its benchmark short-term rate steady at 4.5 per cent.

Some equity bulls even suggested that, with inflationary pressure subdued and the US property market looking precarious, the Fed could even begin cutting interest rates again in the second half of the year to avert a real estate bust.

John Ryding, chief US economist at Wall Street investment house Bear Sterns, says they are guilty of wishful thinking. 'The death of inflation is a story that has been told too soon,' he argues.

Mr Ryding points to sky-high commodity prices and cites the Thai government's threats to imprison people for hoarding sugar as wholesale prices surge. 'That's a real example of inflation in a commodity,' he says.

Along with a clutch of other Wall Street economists, Mr Ryding is warning that incipient inflation could persuade new Fed chairman Ben Bernanke to keep on raising interest rates after he takes over from Alan Greenspan following this month's meeting.

Ethan Harris and Joseph Abate at Lehman Brothers in New York predict that the Fed will make two further increases after the one they expect at the end of this month, pushing the short-term rate to 5 per cent. Economists at Morgan Stanley agree.

A US interest rate - and by extension a Hong Kong rate - of 5 per cent will hardly spell the end of the world. Mr Ryding believes that it will not even substantially wound the US housing market.

'Too great a weight has been given to the US market as a growth driver,' he says, adding that, at most, higher rates will reduce property-related spending by about US$75 billion this year. Corporations flush with cash and ready to begin spending again will easily plug the gap.

Where further US interest-rate increases will hurt, warns Malcolm Wood, Asian equity strategist at Morgan Stanley, is Hong Kong. With the US economy relatively untroubled by higher interest rates, 'Hong Kong is probably the epicentre of this Fed tightening cycle', he says.

Certainly, two extra unexpected rate rises would come as a bitter disappointment to the equity bulls currently pumping money into the Hong Kong exchange in the belief the end of the rate-rise cycle is in sight. If the Fed does follow a rate rise at the end of this month with another in March and a third in May, worsening sentiment will hammer the interest-rate-sensitive banks and property stocks that make up more than half of the Hang Seng Index's capitalisation.

For the canny investor, however, any sell-off could present an attractive opportunity to buy. After all, almost no one expects US interest rates to climb beyond 5 per cent, which, as Mr Wood points out, would be the lowest level at which a cycle of increases has peaked since 1959. Meanwhile, Hong Kong's economy remains healthy and its stocks, at about 14 times forward earnings, are still attractively priced compared with those in the United States.